Historical Cost Concept Definition: Historical cost concept is an accounting concept that states that all assets in the financial statement should be reported based on their original cost, at the time of purchase. Example: James buys a building for $2,000,000 ten years ago, the value of the building now is $3,000,000 but in James’s accounting records, the building is still recorded as $2,000,000 (less depreciation). Historical cost is the original cost of an asset, as recorded in an entity’s accounting records.? A historical cost can be easily proven by accessing the purchase documents.
The historical cost concept is clarified by the cost principle, which states that you should only record an asset, liability, or equity at its original cost. Historical cost is still a central concept for recording assets, though fair value is replacing it for some types of assets, such as marketable investments. What is the advantage of using historical cost on the balance sheet for property, plant and equipment? The main advantage of using historical cost on the balance sheet for fixed assets is that historical cost can be verified.
Generally, the cost at the time of purchase is documented with evidence such as invoices, receipts and etc. Historical costs helps to distinguish an asset’s original cost from its replacement cost, current cost, or inflation-adjusted cost. Furthermore, the historical cost of plants and equipment are used to determine the amount of depreciation expense reported on the income statement. The provision of depreciation is also reported as a deduction from the assets’ historical costs reported on the balance sheet.
The use of historical cost is also a disadvantage to those users of the financial statements who want to know the current values. Disadvantage Historical cost values can relate to transactions that could be as long as 100 years old. Some businesses have old equipment and old stocks (inventories) that are still working well but were bought a long time ago: the problem is that the acquisition value may be out of date and so the balance sheet is showing out of date values. Taxation problems come with inflation accounting.
In times of high levels of inflation, profits are inflated and therefore the tax bill tends to increase: this is the reason that inflation accounting was developed in the UK and elsewhere in the 1970s and onwards. Guess what, though? Accountants found solutions to the inflation accounting problem that led to lower taxation but the Inland Revenue didn’t like what the accountants had done and rejected the accountants’ proposals … and so it went on. Examples 1. 100 units of an item were purchased one month back for $10 per unit.
The price today is $11 per unit. The inventory shall appear on balance sheet at $1,000 and not at $1,100. 2. The company built its ERP in 2008 at a cost of $40 million. In 2010 it is estimated that the present value of the future benefits attributable to the ERP is $1 billion. The ERP shall stand on balance sheet at its historical costs less accumulated depreciation. The concept of historical cost is important because market values change so often that allowing reporting of assets and liabilities at current values would distort the whole fabric of accounting.