Historical Cost Convention

Historical Cost Convention Accounting Historical Cost Financial Reporting Asset Valuation Modified Historical-Cost Convention
The accounting principle under which assets are recorded and carried in the books of account at their original purchase cost.
On this page

Historical Cost Convention

Definition

The Historical Cost Convention is an accounting principle under which assets are recorded in the books of account at their purchase price without considering their current market value. This convention ensures that the asset’s value remains consistent over its lifetime in the financial statements, providing a clear and verifiable cost baseline.

Key Features

  • Verifiability: The original purchase cost of an asset can be verified through original invoices and receipts, ensuring objectivity.
  • Stability: The asset remains recorded at its historical cost, providing stability in the financial statements despite market fluctuations.
  • Depreciation: Over time, assets recorded under historical cost convention are subject to depreciation which is also based on the historical cost.

Examples

  1. Machinery Purchase: A company purchases machinery for $50,000. In its financial statements, the machinery will continue to be valued at $50,000, minus any accumulated depreciation.
  2. Real Estate: A business buys a property for $200,000. Even if the market value of the property increases to $250,000, it is still recorded at $200,000 in the accounting books as per historical cost convention.
  3. Office Equipment: Office equipment purchased at $10,000 remains recorded at that price throughout its useful life, ensuring the cost base remains consistent.

Frequently Asked Questions (FAQs)

What is the main advantage of using the historical cost convention?

The main advantage is the reliability and verifiability of financial records as the recorded cost can be directly traced back to transactional documents like purchase receipts or invoices.

Are there any disadvantages of using the historical cost convention?

Yes, the primary disadvantage is that it can result in outdated asset values on the financial statements, which might not reflect the current market value of the assets.

How does the historical cost convention affect asset depreciation?

Depreciation is calculated based on the historical cost of the asset, not its current market value. This means that the expense allocation over the asset’s useful life might not accurately reflect its current replacement cost.

Can historical cost be adjusted?

No, under the historical cost convention, assets are not adjusted for inflation or changes in market value. However, other accounting conventions may allow revaluation.

  • Modified Historical Cost Convention: A variation where historical costs are adjusted for inflation or other factors while maintaining the original transaction basis.
  • Current Cost Convention: An accounting principle where assets are valued at their current market price.
  • Fair Value: The price at which an asset could be exchanged between knowledgeable, willing parties in an arm’s-length transaction.

Online References

  1. Investopedia on Historical Costs
  2. Accounting Dictionary Definition

Suggested Books for Further Studies

  1. “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
  2. “Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports” by Thomas Ittelson
  3. “Accounting Principles: A Business Perspective” by Roger H. Hermanson, James Don Edwards, and Michael W. Maher

Accounting Basics: “Historical Cost Convention” Fundamentals Quiz

### What is the historical cost convention in accounting? - [x] The practice of recording assets at their original purchase cost - [ ] The practice of recording assets at their current market value - [ ] The practice of adjusting asset values for inflation - [ ] The practice of recording assets at their potential sale price > **Explanation:** The historical cost convention involves recording and carrying the original purchase cost of assets in the financial statements. ### Which accounting convention involves not adjusting asset values for market fluctuations? - [x] Historical Cost Convention - [ ] Market Value Convention - [ ] Fair Value Convention - [ ] Revenue Recognition Convention > **Explanation:** Under the historical cost convention, asset values are not adjusted for market fluctuations and remain recorded at their original purchase cost. ### An asset was purchased for $10,000, and its current market value is $15,000. What value will be recorded under historical cost convention? - [ ] $15,000 - [x] $10,000 - [ ] The average of purchase and market value - [ ] $12,500 > **Explanation:** As per the historical cost convention, the asset will be recorded at its purchase price of $10,000. ### How is depreciation calculated under the historical cost convention? - [ ] Based on current market value - [x] Based on the original purchase price - [ ] Adjusted for inflation - [ ] None of the above > **Explanation:** Depreciation under historical cost is calculated based on the asset’s original purchase price. ### Which of the following is true about the historical cost convention? - [ ] It helps reflect current market value - [ ] It can be adjusted for inflation - [x] It provides a verifiable value basis - [ ] None of the above > **Explanation:** The historical cost convention provides a verifiable and objective value basis by recording assets at their original purchase cost. ### What major disadvantage exists in using the historical cost convention? - [ ] It does not reflect the current market value of assets - [ ] It complicates depreciation - [x] It may show outdated asset values - [ ] It is difficult to verify > **Explanation:** A significant disadvantage is that it may present outdated asset values that do not reflect current market conditions. ### What is a related term that involves adjusting historical costs? - [ ] Fair Value - [ ] Market Value - [x] Modified Historical Cost Convention - [ ] Revenue Recognition > **Explanation:** The Modified Historical Cost Convention adjusts historical costs for inflation or other factors. ### Why might a company prefer historical cost over current cost convention? - [ ] To reflect higher values - [ ] To adjust for inflation - [x] To provide stability and verifiability - [ ] To show lower debt ratio > **Explanation:** Companies might prefer historical cost for its stability and verifiability as the recorded cost can be directly traced back to transactional documents. ### Under which scenario does historical cost provide the most benefit? - [ ] Rapidly changing prices - [ ] Hyperinflation - [x] Stable market conditions - [ ] Speculative asset sales > **Explanation:** Historical cost is most beneficial under stable market conditions since it provides consistent and verifiable asset values. ### Which aspect of financial statements does historical cost convention primarily affect? - [ ] Income statement - [ ] Cash flow statement - [x] Balance sheet - [ ] Dividend statement > **Explanation:** The historical cost convention primarily affects the balance sheet by determining the recorded values of assets.

Thank you for exploring the intricate details of the historical cost convention with us. Keep honing your accounting expertise!

Tuesday, August 6, 2024
Historical Summary
Historical Cost Accounting
Accrued Depreciation January 1, 1
Contra-Asset Account January 1, 1
Depreciation January 1, 1
Net Book Value (NBV) January 1, 1
Revaluation January 1, 1
Wear and Tear January 1, 1
Accounting Cycle January 1, 1
Accounting Principles January 1, 1
Accounting Standards Committee (ASC) January 1, 1
Accrued Taxes January 1, 1

Accounting Terms Lexicon

Discover comprehensive accounting definitions and practical insights. Empowering students and professionals with clear and concise explanations for a better understanding of financial terms.