What is Historical Cost Principle Definition
Historical cost principle refers to the cost of an item it possesses in an arm’s length transaction. In other words, historical cost is the cost paid against anything at the time of acquisition.
Assets are recorded at the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the fair value of the consideration received in exchange of incurring the obligations at the time they were incurred. Historical cost means the original cost an asset that it possesses on the date of its acquisition. This cost is not affected by later inflation/ deflation in its market value. Under historical cost principle assets and liabilities shall be reported in the balance sheet when they were originally acquired at their then acquisition cost and not at their current market value.
Explanation Historical Cost in Accounting
We know that accounting is basically an art to record business transactions from the facts and evidences of past happenings. Entries are made to the books of account once the relevant transaction/dealing has already taken place in past. Facts and evidences are gathered from that past happenings and thus record is updated. Since the completion and accuracy of the accounting record is heavily dependent upon the evidences and information retrieved from past happenings, the accountants and record keepers feel no difficulty in adopting historical cost for record purposes. This is because the historical cost can easily be used as the most objective measurement of item acquired as it is fairly supported by the evidences of transaction. Historical cost is a fundamental concept of accountancy which is based on the historical record of transactions. It would mean that an asset is ordinarily recorded at cost it has at the time of acquisition and the same cost is then used for onward accounting for that asset. If a building is acquired for a cost, say $ 10,000/-, this will be recorded in the books of account with the same value without considering the market price of this building at any other point of time.
It follows from this concept that if nothing is paid to acquire the asset, it will not be recorded at all. Let us take the example of goodwill. Goodwill is only recorded in the books when it is actually purchased.
However, this accounting concept is modified in practice by applying the concept of conservatism such as valuation of closing stocks at lower of cost or net realizable value. Further, if due to some serious reasons the market values of the assets change drastically with the passage of time, it becomes quite mandatory to reflect these changes. Thus, assets are got revalued by professionals and record is changed/updated accordingly.
This accounting principle produces uniformity in accounting record provided the condition of prices remains stable. But this concept also has a major drawback in the event of rapid inflation around the region. If a business does not take the effects of inflation into account, this would definitely lead to imprecise calculation of income. Since the historical costs are matched against the current income, there will be an understatement of value of such assets and overstatement of net income.
The dependency of the business on historical cost principle is not unusual. Many alternative concepts have also been introduced to replace this concept, but still it is viewed as the most realistic and pragmatic.
Examples
The cost of fixed assets includes invoice price, freight charges, delivery cost, installation charges and all those charges that are required to bring assets to their intended use. Thus, all such charges make up a cost of an asset and this cost shall be reported on the balance sheet as a historical cost and shall not be affected by any increase/ decrease in its current value.
A company acquires a vehicle in year 2010 at a cost of $ 2,500/-. At the end of the year market value of vehicle is $ 3,000/-. Although current value increases by $ 500 but this increase in value does not affect the cost to be reported in the balance sheet.
Let suppose in the above example vehicle is sold at $ 3,200/- in year 2011. The company records sale of $ 3,200/- while cost of sale remains $ 2,500/- being the historical cost. The difference of $ 700/- shall wholly be recognized in year 2011 as gain on disposal in the income statement.