Definition of Historical Cost Principle in Accounting: Stability in Financial Reporting l Learn 5 Important Differences Between Historical Cost Accounting and Fair Value Accounting: A Deep Dive
The Historical Cost is one of the most important concepts in accounting. In very simple words, “the monetary value what is paid to acquire the ownership of assets or what the business agreed to pay on the later date”. In other words, the monetary value of acquisition or original purchase price of an asset is called the “Historical Cost“.
Historical Cost Concept in Accounting; Image Source: AI
Historical Cost Concept in Accounting
As per the accounting principle, all the assets and liabilities must be recorded at their original acquisition cost in the company’s books (such as – balance sheet) regardless of market value and it includes all necessary costs to prepare the asset for its intended use.; no matter what the present monetary value is if sold today. When a company acquires an asset and make payment or promise to pay on a later date, the acquisition cost of the asset may be higher or lower than the market value of that time. The conservatism principle of accounting says that all the long-term assets must be adjusted for their usage during their expected useful life, and to do this the Depreciation expense is charged for Tangible Assets and Amortization expense is charged for Intangible assets in the company’s income statement.
Example
Let’s assume that a hypothetical manufacturing company named XYZ Limited buys machineries for it manufacturing operations for INR 15 lakh (without tax), and company has to pay INR 1.80 lakh as 12% tax on purchase price. The additional cost (such as – transportation to manufacturing site, insurance etc.) of INR 20,000/- is necessary and directly associated with the aforementioned machineries to make them ready to use.
How do you calculate Historical Cost (Formula)
Historical Cost = Original Purchase Price + Directly Associated All Additional Costs
The accounting and financial principles allow us that, company’s long-term assets (non-current assets) must be adjusted as “wear and tear” for their usage over their useful life, and now the concept of “Depreciation” comes in play which is used to adjust (reduce) the value of long-term assets over their useful life. Companies use the “Straight Line Method” to depreciate (reduce / adjust) the assets. For example – If XYZ Limited assumes the 10 years of useful life of machineries then – XYZ Limited will adjust INR 20,000.00 every year till last assumed 10th year as depreciation for machineries in their books (INR 2,00,000 is divided by 10(years) is equal to INR 20,000.00, and this method is called “Straight Line Method”).
Image Source: AI
5 Important Differences Between Fair Value Accounting (Mark-to-Market) and Historical Cost Accounting
Historical Cost Accounting Principle focuses on the original purchase cost plus additional all associated direct cost, while Fair Value Accounting Principle focuses on the present market value.
Historical Cost doesn’t care of inflation and doesn’t change over time. Values recorded under the Fair Value Accounting principles can fluctuate over time, as it focuses on current market value and affected by the inflation.
Historical Cost applies for inventory and long-term assets or company’s fixed assets, while Fair Value is used for accounts receivable, bonds, stock market, derivatives and marketable securities.
Historical Cost Accounting doesn’t represent the real time worth of an asset or liability, but Fair Value Accounting represents real time worth.
Historical Cost Accounting provides the reliable insights of a company over a period of time, but Fair Value Accounting provides current and up-to-date insights about a company.
Conclusion
Historical Cost Accounting (HCA) is a conservative accounting method which prevents the assets from over-estimation. It isn’t affected by market ups and downs. This accounting method doesn’t much care of market’s volatility, to wit, no matter that market value or current price is very high or very low. Historical Cost Accounting method assess the assets and/or liabilities at their historical cost. It is used to obtain long-term insights.
