Historical cost is a traditional method of recording assets and liabilities at their original or nominal value without making adjustments for inflation. It first came in evidence in Jun 1979 in a French project after numerous debates. The historical cost principle states that the asset should include all cost necessary to get the asset in place and ready for use. The principle of historical cost is based upon two fundamental principles: the principle of monetary standardization and principle of prudence. The principle of monetary standardization ignores the fluctuations in monetary values of asset and liability.
The principle of prudence accounts only the losses but ignores potential profit. Assets are evaluated based on acquiring cost, stock is evaluated based on net realizable value or lower cost and debt according to nominal value not present value.
Under U.S GAAP ( Generally Accepted Accounting Principles) most assets are recorded at historical cost except for certain financial instruments like trading securities, available for sale securities, derivatives.
Under IFRS (International financial Reporting Standards) historical cost is acceptable but not required for property plant and equipment but intangible assets, property, plant and equipment, and investment property may be revalued to fair value. But revaluation will have to be applied to all assets of particular class and they have to make sure this done with regularity so that there is not that large difference between carrying value and market value. Even though in historical cost there is no routine adjustments for inflation but for calculating book value calculations like depreciation, amortization, depletion are done.
Historical cost reflects the real value of items at the date of their entering the company.
Historical cost is truly more sure, reliable and checkable value. For asset it is the amount paid or to be paid and in case of debt it is the value of equivalents obtained in exchange of obligation or the value to be paid in cash or cash equivalents to settle the debt. Historical cost is more accurate and relevant to make economic decisions since affects the evaluation and selection of decision rule. In order to make decisions and decide which decision rule to choose it needs information which is of same quality of past decisions. Even for making forecast past data is needed as a basis for forecasting which facilitates decision making in an organization. For example- for forecasting price for the next year a company needs past prices as a basis. Moreover it concentrates on what has been earned rather than what could have been earn. Current value accounting anticipates profits that may never be realized. If (for example) the current market prices of property or investments are very different from their historical cost, this information can be disclosed in the notes to the financial statements.
There is no need to adjust the amounts in the statement of financial position or the other primary statements. Accounting data under historical cost is subject to less manipulation because the data obtained came from actual transaction rather than from projected or estimated data. The accountants just record it according to the acquired price. As a result it is reported and measured objectively which helps to minimize manipulation of accounting data. The record of past transaction also helps managers to keep accountability and control since they are accountable to the shareholders. For using as a standard, historical cost can be ascertained easily and economically from past accounting records. The major limitation of historical cost is that there is no consideration of changes in price level. Financial statements prepared under historical cost accounting are composed of past data. Changes in monetary value due to change in general price level is not considered.
As a result it fails to provide true and fair value in the financial reports. It also leads to unrealistic value of fixed assets, the most striking example is a property or land. It ignores the market value and considers the acquiring cost. Depreciation is a non-cash expense it aims to create a fund to replace the asset when it becomes obsolete. In historical cost accounting the calculation of depreciation is based on historical cost not on the market value so the fund available at the end of the economic life may not be sufficient for the replacement. Thus it creates insufficient provision for depreciation. It also creates unrealistic profit because the revenues are based on current market price whereas the expenses like depreciation is based on historical cost. As a result it overstate profit. Holding gains on inventories are included in profit.
During a period of high inflation the monetary value of inventories held may increase significantly while they are being processed. The conventions of historical cost accounting lead to the unrealized part of this holding gain (known as inventory appreciation) being included in profit for the year. Moreover for companies in the service sector or which invest huge amount of capital in technology reflects poorly the true potential. According to prudence concept it accumulate all losses not profit which hide its real potential. Information based on historical cost gives a invalid trend of the company because the result are not adjusted for changes in prices. Only if the value were adjusted the comparison would have been fair. Historical cost no longer reflect economic reality.
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