Historical cost

3 key takeaways

• Historical cost is the actual cost paid for an asset or incurred for a liability, recorded in financial statements at its original value.
• This method provides a reliable and objective basis for accounting, as it is based on verifiable transactions.
• Historical cost does not account for changes in market value, which can lead to discrepancies between book value and current market value.

What is historical cost?

Historical cost is an accounting principle that records assets and liabilities at their original purchase price or the amount originally incurred. This cost remains unchanged on the balance sheet regardless of changes in the market value of the asset or liability. For example, if a company buys a piece of machinery for £50,000, it will be recorded at that amount in the company’s financial records, even if the market value of the machinery changes over time.

This approach is rooted in the concept of reliability and verifiability. The historical cost of an asset or liability is based on actual transactions that can be documented, making it an objective measure for financial reporting.

Advantages of historical cost

One of the primary advantages of historical cost is its reliability. Because historical costs are based on actual transactions, they can be easily verified through invoices, receipts, and other documentation. This makes financial statements more reliable and less subject to manipulation or estimation errors.

Moreover, historical cost accounting provides consistency in financial reporting. By recording assets and liabilities at their original purchase prices, companies can maintain a stable and consistent basis for financial reporting over time. This consistency is valuable for comparing financial statements across different periods and for conducting audits.

Limitations of historical cost

Despite its reliability, historical cost has some limitations. One significant drawback is that it does not reflect the current market value of assets and liabilities. Over time, the value of assets such as real estate, equipment, and inventory can change due to factors like inflation, technological advancements, and market conditions. As a result, the historical cost may not provide an accurate picture of a company’s current financial position.

For example, if a piece of property was purchased for £100,000 several years ago but is now worth £300,000, the historical cost accounting method would still record it at £100,000. This discrepancy can lead to a lack of relevance in financial statements for decision-makers who need up-to-date information about the company’s assets.

Applications of historical cost

Historical cost is widely used in various accounting practices, particularly for the initial recording of fixed assets, inventory, and liabilities. It is a fundamental concept in financial accounting and is mandated by many accounting standards and regulatory frameworks, including Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

In practical applications, historical cost is used for calculating depreciation of fixed assets, assessing historical financial performance, and ensuring compliance with auditing requirements. While it may be supplemented with other valuation methods, such as fair value accounting, historical cost remains a cornerstone of traditional accounting practices.

Related topics

• Fair value accounting
• Depreciation
• Amortization
• Financial reporting standards

Explore these related topics to enhance your understanding of different accounting principles and their impact on financial reporting.