Historical Cost Convention
Definition
The Historical Cost Convention is an accounting principle under which assets are recorded in the books of account at their purchase price without considering their current market value. This convention ensures that the asset’s value remains consistent over its lifetime in the financial statements, providing a clear and verifiable cost baseline.
Key Features
- Verifiability: The original purchase cost of an asset can be verified through original invoices and receipts, ensuring objectivity.
- Stability: The asset remains recorded at its historical cost, providing stability in the financial statements despite market fluctuations.
- Depreciation: Over time, assets recorded under historical cost convention are subject to depreciation which is also based on the historical cost.
Examples
- Machinery Purchase: A company purchases machinery for $50,000. In its financial statements, the machinery will continue to be valued at $50,000, minus any accumulated depreciation.
- Real Estate: A business buys a property for $200,000. Even if the market value of the property increases to $250,000, it is still recorded at $200,000 in the accounting books as per historical cost convention.
- Office Equipment: Office equipment purchased at $10,000 remains recorded at that price throughout its useful life, ensuring the cost base remains consistent.
Frequently Asked Questions (FAQs)
What is the main advantage of using the historical cost convention?
The main advantage is the reliability and verifiability of financial records as the recorded cost can be directly traced back to transactional documents like purchase receipts or invoices.
Are there any disadvantages of using the historical cost convention?
Yes, the primary disadvantage is that it can result in outdated asset values on the financial statements, which might not reflect the current market value of the assets.
How does the historical cost convention affect asset depreciation?
Depreciation is calculated based on the historical cost of the asset, not its current market value. This means that the expense allocation over the asset’s useful life might not accurately reflect its current replacement cost.
Can historical cost be adjusted?
No, under the historical cost convention, assets are not adjusted for inflation or changes in market value. However, other accounting conventions may allow revaluation.
Related Terms
- Modified Historical Cost Convention: A variation where historical costs are adjusted for inflation or other factors while maintaining the original transaction basis.
- Current Cost Convention: An accounting principle where assets are valued at their current market price.
- Fair Value: The price at which an asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction.
Online References
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports” by Thomas Ittelson
- “Accounting Principles: A Business Perspective” by Roger H. Hermanson, James Don Edwards, and Michael W. Maher
Accounting Basics: “Historical Cost Convention” Fundamentals Quiz
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