Definition
The system of accounting in which assets are valued and depreciation allowances are calculated for firms using the prices paid for assets when they were first bought or built. The merit of this system is that it uses prices based on actual market transactions; any other method of accounting for assets involves using valuations not based on market transactions. Historical cost accounting has the drawback that in a period of sustained inflation it systematically undervalues assets and calculates depreciation allowances well below the replacement costs of capital goods, so that profits are systematically overestimated.
Historical Context
Historical cost accounting has been a foundational principle in financial accounting for centuries, dating back to the practices of early merchants and tradesmen. As economies evolved, the need for consistent and reliable asset valuation led to the adoption of historical cost accounting as a standard practice.
Key Events
- 19th Century: Early adoption by businesses to standardize financial records.
- 1930s: Introduction of the Generally Accepted Accounting Principles (GAAP) which incorporated historical cost as a core principle.
- 1970s: Increased scrutiny during periods of high inflation led to the exploration of alternative accounting methods.
Detailed Explanations
Types/Categories
- Fixed Assets: Long-term assets such as property, plant, and equipment.
- Current Assets: Short-term assets like inventory and accounts receivable.
Importance and Applicability
The historical cost principle provides a reliable and verifiable method for asset valuation. It is widely used because it offers:
- Consistency: Ensuring comparable financial statements over time.
- Objectivity: Based on actual transactions rather than subjective estimates.
- Legal Compliance: Often required by regulatory bodies and accounting standards.
Mathematical Formulas/Models
Depreciation Calculation
Depreciation based on historical cost can be calculated using various methods:
- $$ \text{Depreciation Expense} = \frac{\text{Historical Cost} - \text{Salvage Value}}{\text{Useful Life}} $$
- $$ \text{Depreciation Expense} = \text{Book Value at Beginning of Year} \times \text{Depreciation Rate} $$
Charts and Diagrams
graph TD
A[Historical Cost] --> B[Fixed Assets]
A --> C[Current Assets]
B --> D[Property]
B --> E[Plant]
B --> F[Equipment]
C --> G[Inventory]
C --> H[Accounts Receivable]
Examples
- Company X purchases machinery for $100,000. Under historical cost accounting, the machinery is recorded at this price, regardless of market value changes.
Considerations
- Inflation Impact: Historical cost can understate the value of assets and depreciation during inflation.
- Profit Overestimation: Can lead to higher reported profits, impacting financial analysis.
Related Terms with Definitions
- Fair Value Accounting: Valuation method based on current market prices.
- Replacement Cost: The cost to replace an asset at current market prices.
- Depreciation: Allocation of the cost of tangible assets over their useful lives.
Comparisons
| Historical Cost | Fair Value Accounting |
|---|---|
| Based on original cost | Based on market value |
| Less affected by volatility | More affected by market fluctuations |
Interesting Facts
- Historical cost accounting is often criticized for not reflecting the true economic value of assets, especially in hyperinflationary environments.
Inspirational Stories
During the 1970s inflation crisis, several businesses faced challenges with overvalued profits due to historical cost accounting. This prompted innovations in accounting practices, fostering greater accuracy in financial reporting.
Famous Quotes
- “Historical cost accounting emphasizes objectivity and reliability over relevance.” - Anonymous Accountant
Proverbs and Clichés
- “A penny saved is a penny earned.” - Reflecting the principle of conserving resources based on their original value.
Expressions
- “At cost”: Referring to the price paid for an asset.
Jargon and Slang
- “Book Value”: The value of an asset as recorded in the books.
- “Historical Price”: The original cost paid for an asset.
FAQs
Q: Why is historical cost important?
- A: It provides a consistent and objective method for asset valuation based on actual transaction prices.
Q: What is the drawback of historical cost accounting?
- A: It can understate asset values and depreciation during inflationary periods.
References
- Investopedia: Explanation and examples of historical cost accounting.
- Financial Accounting Standards Board (FASB): Guidelines on asset valuation and historical cost.
- International Financial Reporting Standards (IFRS): Standards addressing historical cost accounting practices.
Summary
Historical cost accounting remains a cornerstone of financial reporting due to its objectivity and reliability. However, its limitations, especially during periods of inflation, necessitate the use of supplementary valuation methods to provide a comprehensive financial overview. Understanding the principles and applications of historical cost is crucial for accurate and transparent financial analysis.
