Historical Cost: Meaning, Examples and Advantages

Historical cost records assets and liabilities at their original purchase price, emphasizing objectivity and verifiability. It maintains financial stability by ignoring market value fluctuations, providing a consistent basis for financial reporting and analysis. Let's understand Historical cost as an essential accounting concept in detail. 

Why does a house bought for ₹50 lakhs 10 years ago still show as ₹50 lakhs in financial records despite its market value doubling? This is due to the historical cost principle, a fundamental accounting approach that records assets and liabilities at their original purchase price. Unlike fair value or replacement cost, which adjusts for market changes, historical cost offers a stable, clear snapshot of past financial decisions. It's a method that ensures the financial statements' reliability by anchoring them to verifiable transactions, but it also raises questions about reflecting true asset value over time. Let’s understand essential accounting concepts in detail with the help of examples. 

Table of Content

• What is Historical Cost?
• Example of Historical Cost
• How is Historical Cost Calculated?
• Advantages of Historical Cost
• Disadvantages of Historical Cost

What is Historical Cost?

The historical cost concept is also known as the cost principle. It is an accounting principle that states that assets, liabilities or equities should be recorded and reported at their original purchase price or cost at the time of acquisition. According to this concept, all values are initially recorded on the balance sheet at the price paid to acquire them. It includes all costs necessary to prepare the asset for its intended use.

Under the historical cost concept, assets are not revalued over time to reflect changes in market value or inflation. Instead, they remain recorded on the balance sheet at their original cost unless they are impaired or deemed to have lost value over time. This principle provides objectivity and reliability to financial statements by ensuring that transactions are recorded based on verifiable and objective evidence.

Example of Historical Cost

Imagine a business in India buying a piece of machinery for ₹10 lakhs in 2020. This ₹10 lakhs is the historical cost and is recorded as the asset's value in the financial statements. Over time, the machinery may depreciate or even increase in market value. Still, for accounting purposes, it remains valued at its purchase price of ₹10 lakhs, reflecting the historical cost principle, ensuring consistency and reliability in financial reporting.

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How is the Historical Cost Calculated?

The calculation of historical cost involves recording the purchase price of an asset, liability, or equity at the time of the transaction, along with any additional expenses directly related to acquiring, installing, and making the asset ready for use. Here’s a step-by-step breakdown of how historical cost is typically calculated for an asset:

Purchase Price: Start with the actual cash or equivalent paid for the asset. This is the base amount of the historical cost.

For example, A business purchases a delivery vehicle for ₹500,000. This amount is the initial figure for historical cost calculation.

Acquisition Costs: Add any costs directly associated with acquiring the asset. This can include import duties, taxes, transportation costs, handling fees, and any legal or documentation fees incurred during the purchase.

Continuing with the above example, To get the vehicle operational, the business incurs additional costs:

• Registration fees: ₹10,000
• Insurance premium for the first year: ₹15,000
• Transportation and delivery charges to bring the vehicle to its operational location: ₹5,000

Installation and Setup: Include the costs of preparing the asset for its intended use. This can involve installation fees, costs of constructing foundations for machinery, and any initial setup or testing fees.

Since it's a vehicle, there might not be significant installation costs, but let's assume there's a need for minor modifications to fit the business's specific needs:

Vehicle modification: ₹20,000

Adjustments for Discounts and Incentives: Subtract any purchase discounts received at the time of buying the asset. Additionally, factor in any rebates or incentives that effectively reduce the purchase price.

Calculation of Historical Cost

Now, let's calculate the historical cost of the vehicle:

Purchase Price: ₹500,000

Add: Acquisition Costs:

Registration fees: ₹10,000

Insurance: ₹15,000

Transportation and delivery: ₹5,000

Add: Installation and Setup:

Vehicle modification: ₹20,000

Less: Discount: ₹25,000

Historical Cost Calculation:

₹500,000+(₹10,000+₹15,000+₹5,000+₹20,000)−₹25,000=₹525,000

Therefore, the historical cost of the delivery vehicle that will be recorded on the balance sheet is ₹525,000. This is the cost that will be used for accounting purposes, such as depreciation calculations, regardless of any future changes in the vehicle's market value.

The sum of these elements gives you the historical cost of the asset. This cost becomes the asset's initial value on the balance sheet and is the basis for subsequent accounting treatments, such as depreciation or impairment calculations.

For liabilities, the historical cost is the value of the consideration received in exchange for incurring the liability, adjusted for any transaction costs or discounts.

Advantages of Historical Cost

The Historical Cost Concept, despite its critics, offers several advantages in accounting:

Objectivity: Historical cost is based on actual transactions and is supported by verifiable evidence such as invoices, receipts, and contracts. This provides objectivity and reliability to financial statements, as it reduces the subjectivity in determining the value of assets.

Simplicity: The historical cost concept is simple and easy to apply. It involves recording assets at their original purchase price, which makes accounting processes less complex compared to methods that involve revaluation or estimation of asset values.

Consistency: Since assets are recorded at their historical cost, financial statements maintain consistency over time. This consistency enhances comparability between different periods and allows users to analyze financial performance and trends accurately.

Stability: Historical cost provides a stable and reliable basis for recording assets, especially during economic uncertainty or market volatility. It shields financial statements from fluctuations in market values and reduces the potential for manipulation or distortion of asset values.

Legal and Regulatory Compliance: The historical cost concept is widely accepted and recognized by accounting standards and regulatory bodies around the world. Adhering to historical cost principles helps companies comply with legal and regulatory requirements governing financial reporting.

Audit Trail: Using historical cost creates a clear audit trail, as it documents the original acquisition cost of assets and facilitates the verification of transactions during audits. This transparency enhances the reliability and credibility of financial statements.

Disadvantages of Historical Cost

Lack of Relevance: Historical costs may not reflect the current market value of assets, especially during inflation, deflation, or significant changes in market conditions. As a result, financial statements based on historical cost may not provide users with timely and relevant information for decision-making.

Potential for Over/Understatement: Assets recorded at historical cost may be overvalued or undervalued compared to their current market values. This discrepancy can distort the true financial position of a company and lead to misleading financial statements, particularly if assets have significantly appreciated or depreciated since their acquisition.

Distorted Profitability: Historical cost does not reflect changes in asset values over time, so it can distort profitability measures, such as net income and return on investment. For example, suppose assets are recorded at historical cost but have significantly appreciated. In that case, the company's reported profits may be understated, and its return on investment may appear lower than it is.

Limited Decision-making Ability: Users of financial statements, such as investors, creditors, and stakeholders, may find it challenging to make informed decisions based solely on historical cost information. They may prefer more relevant and reliable measures of asset values, such as fair value accounting, which reflects current market prices.

Potential for Manipulation: While historical cost provides objectivity and reliability, it can also be manipulated by management seeking to portray a more favorable financial position. Management may selectively revalue assets or manipulate depreciation schedules to enhance reported earnings or financial ratios.

Complexity in Comparisons: Comparing financial statements of companies that use different accounting methods, such as historical cost versus fair value accounting, can be challenging. The lack of consistency in asset valuation methods may hinder meaningful comparisons between companies and industries.

Inadequate Representation of Intangible Assets: Historical cost may not adequately capture the value of intangible assets, such as patents, trademarks and goodwill, which often appreciate in value over time but are not typically revalued under the historical cost concept.

Conclusion

The historical cost concept serves as a foundational principle in accounting, offering simplicity, objectivity, and stability in financial reporting. It provides a reliable basis for recording assets at their original acquisition cost, ensuring consistency and accuracy in financial statements. However, despite its merits, historical cost has several limitations that impact its relevance and usefulness in contemporary business environments.