Definition
Historical Cost Accounting is a method of accounting in which assets and liabilities are recorded on the balance sheet at their original cost when acquired, ignoring changes in market value. This method is used to provide tangible and verifiable records of transactions.
Characteristics:
- Objective and Verifiable: The original cost is based on an actual transaction and is therefore considered to be objective and easy to verify through historical records.
- Stable and Consistent: This method provides stability in accounting records as the value assigned does not fluctuate with market conditions.
- Ease of Application: Since it involves recording the original purchase price, it is relatively simple to implement.
- Helps in Audit Verification: The unchanging figures make it easier for auditors to verify the accuracy of the financial statements.
Criticisms:
- Inflation Impact: In times of high inflation, historical cost accounting can result in asset values being understated and profits overstated.
- Relevance Issues: Current values may be more relevant for decision-making compared to historical values, which may lead to impracticality when dealing with modern, complex financial instruments like derivatives.
- Capital Maintenance: Historical costs do not account for the real purchasing power of invested capital over time.
Examples
- Property Purchase: A company purchases a building for $500,000 in the year 2000. Under historical cost accounting, the building will remain recorded at $500,000 despite its market value changes over the years.
- Machinery Acquisition: A factory buys equipment for $100,000. Despite depreciation charges, the initial recording in the accounts will reflect the original purchase price.
- Inventory Valuation: Historical costs may result in recorded inventory costs different from current market prices - leading to possible discrepancies in terms of liquidity assessment.
Frequently Asked Questions
Q: Why is historical cost accounting criticized during inflationary periods?
A: During periods of high inflation, the buying power of money decreases, meaning that the historical costs recorded may not accurately reflect the current market value of assets, hence leading to potentially misleading financial statements.
Q: Can companies choose not to use historical cost accounting?
A: Yes, many companies now employ fair value accounting practices under the guidance of recent standards to provide a more accurate reflection of current asset and liability values.
Q: How does historical cost accounting handle depreciation?
A: Depreciation under historical cost accounting is calculated based on the asset’s original cost, spreading this cost over its useful life.
Q: What are the main advantages of historical cost accounting?
A: Historical cost accounting offers objectivity, ease of application, stability, resistance to manipulation, and facilitates audit verification.
Q: How does historical cost accounting compare with fair value accounting?
A: Fair value accounting provides current market value assessments while historical cost accounting relies on original transaction values. Fair value can offer more relevancy for current decision-making, though it may introduce more volatility.
Related Terms
- Net Realizable Value: The estimated selling price in the ordinary course of business, minus the costs of completion, disposal, and transportation.
- Revaluation of Fixed Assets: Re-assessment of the carrying value of fixed assets to reflect current market values.
- Stewardship: Accountability of management for safeguarding the company’s assets and management performance.
- Capital Maintenance: Concept ensuring that a company’s capital is at least maintained in nominal or real terms.
- Derivatives: Financial contracts deriving value from an underlying asset or benchmark.
- Fair Value Accounting: Measurement based on current market prices rather than historical costs.
- Financial Statements: Formal records of the financial activities and position of a business, person, or other entity.
- Alternative Accounting Rules: Optional accounting policies allowing entities to produce financial statements more aligned with user needs.
- Modified Historical Cost Convention: Blended approach combining historical costs with some adjustments reflecting current values.
Online References
- Investopedia Historical Cost
- Financial Accounting Standards Board (FASB)
- International Financial Reporting Standards (IFRS) - Historical Cost
Suggested Books for Further Studies
- Accounting: What the Numbers Mean by David H. Marshall
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Financial Accounting Theory by William Scott
- Principles of Accounting Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper
- Accounting Made Simple: Accounting Explained in 100 Pages or Less by Mike Piper
Accounting Basics: “Historical Cost Accounting” Fundamentals Quiz
### Why is historical cost accounting often praised for its stability?
- [x] Because recorded asset values do not fluctuate with market conditions.
- [ ] Because it produces potential higher market values.
- [ ] Because it incorporates both past and current economic conditions.
- [ ] Because it undergoes frequent adjustments for accuracy.
> **Explanation:** Historical cost accounting maintains asset values at their original transaction cost, making them stable and unaffected by market volatility.
### How does historical cost accounting handle inflation?
- [ ] It automatically adjusts for inflation.
- [x] It ignores changes in market value caused by inflation.
- [ ] It revalues assets to current market prices.
- [ ] It depreciates assets faster during inflationary periods.
> **Explanation:** Historical cost accounting does not account for market value changes due to inflation, which can result in understated asset values and overstated profits during inflation.
### Which type of financial standard is growing in use instead of historical cost accounting due to its perceived relevance?
- [x] Fair value accounting
- [ ] Modified historical cost convention
- [ ] Stewardship
- [ ] Net realizable value method
> **Explanation:** Fair value accounting is gaining preference in certain scenarios where current values are more relevant for decision-making compared to historical costs.
### What is one of the main criticisms of historical cost accounting when dealing with financial derivatives?
- [ ] Derivatives need historical accuracy.
- [ ] Derivatives shouldn’t be included in financial statements.
- [x] Historical costs may not accurately represent their complex financial nature.
- [ ] Historical costs increase manipulation risk.
> **Explanation:** Derivatives are complex financial instruments and their market value often fluctuates, making historical costs inadequate for accurately representing their financial position.
### What is meant by the 'stewardship' function in historical cost accounting?
- [ ] Ensuring assets reflect real-time values.
- [x] Accountability in safeguarding the company's interests.
- [ ] Facilitating market speculation.
- [ ] Enabling rapid asset revaluation.
> **Explanation:** The stewardship function involves management's accountability in safeguarding company resources and effectively managing its assets.
### Why can historical cost accounting be easier for audit verification?
- [ ] It relies on speculative market information.
- [x] Historical costs are based on verifiable transactions.
- [ ] It frequently updates to current values.
- [ ] It eliminates the need for depreciation.
> **Explanation:** Auditors can more easily verify the historical costs as they are based on concrete past transactions, ensuring accuracy and reliability.
### Which of the following is a limitation of historical cost accounting?
- [ ] It fosters constant tip auditing.
- [x] It may be misleading during inflationary periods.
- [ ] It allows easy asset appreciation recording.
- [ ] It avoids feature-based discrepancies.
> **Explanation:** During periods of high inflation, the recorded historical costs may not reflect the asset's true market value, potentially misleading stakeholders about the actual financial position.
### What aspect of historical cost accounting can make it seem more objective?
- [x] The reliance on recorded original transaction costs.
- [ ] Regular market revaluation.
- [ ] It incorporates inflation corrections quarterly.
- [ ] Divides asset value by geographical parameters.
> **Explanation:** The reliance on recorded original transaction costs renders it objective since these costs are verifiable and not based on market estimations.
### How are assets recorded in historical cost accounting after purchase?
- [ ] They adjust monthly following current market trends.
- [x] They remain at the original purchase cost.
- [ ] They are re-valued every financial year end.
- [ ] They undergo regular depreciation and market revaluation.
> **Explanation:** Assets are initially recorded at their purchase cost and remain on the financial statements at this value, not accounting for subsequent market changes unless impairment occurs.
### How does historical cost accounting approach depreciation?
- [x] Based on the original cost over useful life.
- [ ] It does not employ depreciation.
- [ ] According to market revaluations periodically.
- [ ] Overestimates for faster returns.
> **Explanation:** Depreciation under historical cost accounting is determined by spreading the original purchase cost over the asset’s useful life.
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