The historical-cost convention is an accounting principle under which assets are recorded and reported at their original purchase cost. This method maintains the historical cost on financial statements, rather than adjusting for market value fluctuations.
Historical Context
The historical-cost convention emerged in the early 20th century as a foundational principle in traditional accounting practices. Initially, it provided a straightforward and verifiable way to record transactions, which was essential for maintaining consistent and reliable financial records.
Types/Categories
- Pure Historical-Cost Convention: Assets are always recorded and presented at their original purchase cost.
- Modified Historical-Cost Convention: While primarily using historical costs, some assets are revalued periodically to reflect current values, like in certain instances under IFRS (International Financial Reporting Standards).
Key Events
- 1929 Stock Market Crash: The reliability of historical cost came into focus for ensuring transparent financial reporting.
- Adoption of IFRS: Integration of modified historical-cost principles allowed for adjustments to enhance the relevancy of financial statements.
Detailed Explanations
Under the historical-cost convention, the value of an asset is recorded at the price paid at the time of acquisition. This method disregards changes in market value unless impairment is recognized. For example, a piece of machinery bought for $50,000 remains recorded at $50,000 throughout its life, minus any depreciation.
Importance and Applicability
- Stability: Provides consistency and comparability in financial statements over time.
- Objectivity: Based on verifiable transaction records, reducing subjectivity.
- Simplicity: Eases record-keeping and reporting by avoiding frequent market revaluations.
Considerations
- Inflation Impact: Over time, the purchasing power of money changes, which can lead to undervaluation of assets.
- Relevance: The historical cost may not reflect the current market value, limiting the usefulness of financial statements for decision-making.
Examples
- Real Estate: A property purchased for $200,000 in 2000 is still recorded at $200,000, irrespective of its current market value.
- Equipment: Machinery bought for $10,000 continues to be reflected at the original cost minus accumulated depreciation.
Related Terms
- Fair Value: Current market price of an asset or liability.
- Depreciation: The allocation of the cost of an asset over its useful life.
Comparisons
- Historical Cost vs. Fair Value: Historical cost focuses on original purchase price, while fair value reflects current market prices.
Interesting Facts
- Historical cost accounting often leads to “hidden reserves” where asset values are substantially higher than recorded.
Famous Quotes
“Accounting is the language of business.” — Warren Buffett
Proverbs and Clichés
- “A bird in the hand is worth two in the bush.” (Reflecting the certainty of historical costs)
Jargon and Slang
- Book Value: Refers to the net value of an asset as recorded in accounting books.
FAQs
Q: Why use historical cost when market values are available? A: Historical cost provides a consistent and objective basis for financial reporting.
Q: Can assets under historical-cost convention ever be adjusted? A: Typically, only in case of impairment or under modified historical-cost conventions like those sometimes seen in IFRS.
References
- Financial Accounting Standards Board (FASB)
- International Financial Reporting Standards (IFRS)
- “Accounting Theory and Practice” by Glautier and Underdown
Summary
The historical-cost convention remains a cornerstone of traditional accounting, emphasizing reliability and simplicity. Despite its limitations in reflecting current market values, its consistent application ensures comparability across financial periods, contributing to the stability of financial reporting. Understanding this principle helps appreciate the balance between historical accuracy and contemporary relevancy in asset valuation.
