In historical cost accounting, historical cost is the original monetary value of an economic item.
Depreciation effects the carrying value of an asset
on the balance sheet. The historical cost will equal the carrying value if there has been
no change recorded in the value of the asset since acquisition. Improvements may be added to the cost basis of an asset.
Historical cost does not generally reflect current market valuation. Different accounting standards may require that the
carrying value of an asset (or liability) be updated to the market price (mark-to-market
valuation) or some other estimate of value that better approximates the real value. Accounting standards may also have different
methods required or allowed (even for different types of balance sheet assets or liabilities) as to how the resultant change in
value of an asset or liability is recorded, as a part of income or as a direct change to shareholders' equity.
Historical cost calculation
Fixed assets
Historical cost is the actual purchase price plus incidental costs incurred in getting the fixed asset in a condition and
position ready for initial use / commercial production.
- Land: Purchase price + legal fees + costs on leveling, grading, draining, clearing + mortgages, liens, encumbrances +
additional permanent improvements (e.g. pavements, sewers, landscaping) - any proceeds from getting the land ready
for its intended use (e.g. sale of cleared timber or materials from demolished buildings).
Note: Improvements with limited life (e.g. private driveways, walks, fences) are not
included into the price because they are considered land improvements. They are categorized differently because
improvements can be depreciated whereas land cannot.
- Building: Purchase price + legal fees + and costs incurred in respect of major
improvements / alterations / betterments.
However, when building is self-constructed, historical cost will be computed as follows: All direct
costs (material, labour, expenses) + professional fees + legal fees + interests + appropriate share of overheads (fixed, and
variable) [basically, all costs from excavation to completion].
Note: capitalize only lower of actual or avoidable (interest that could have been avoided if
expenditures for the asset had not been made) interests incurred during construction.
- Machinery: Purchase price (net) + freight + shipping + loading & unloading +
installation charges + commissioning (expenses on trial run and experimental production).
- Furniture & Fixtures: Purchase price (net) +
installation charges.
- Vehicles: Purchase price + registration charges + cost incurred on accessories.
Special cases
- Discounts should be considered a reduction in the purchase price.
- If an asset has been received in consideration of issuing shares / bonds or notes
payable, historical cost is recorded at fair market value of shares / bonds or notes payable. For example: machinery is bought in
return of 10,000 shares which have a market value of $12 each at that time, then the historical cost of the machinery is $120,000
(any subsequent change in the value of those shares is accounted for separately).
- If a group of assets are purchased for a single lump sum, the cost paid is allocated among various assets on the basis of
their fair market value.
- If an asset has been received in exchange for another non-monetary asset, historical cost is
recorded as the fair market value of the asset given up or the asset acquired whichever is more evident.
Costs after acquisition
In general, costs incurred to improve an asset should be capitalized (that is, added to the historical price), whereas
expenditures that simply maintain a given level of services should be treated as ordinary expenses. In order for cost to be
capitalized, one of these conditions must be met:
- the useful life of the asset must be increased
- the quality of units produced from the asset must be increased
- the quantity of units produced must be increased.
Depreciation
Historical cost principle
Under U.S. generally accepted accounting
principles (US GAAP), the historical cost principle dictates that most assets and liabilities should be recorded at
their historical cost. For example, a tract of land which was purchased 50 years ago for $10,000 may be worth $1 million today,
but it will be recorded on the balance sheet at its historical cost of $10,000. The
historical cost principle is used because of its reliability and freedom from bias when compared to the fair market value
principle.
Adjustment for current valuation
In the US, the Financial Accounting Standards Board allows
current valuation for certain assets such as marketable securities, impaired assets, and derivatives.[1]
In contrast to US GAAP, under
UK GAAP firms may revalue assets based on appraised market
values. This can result in the recognition of unrealized gains as income.
Adjustment for inflation
Historical cost assumes a stable monetary unit only with regard to constant real value non-monetary items in low inflationary
economies. As PwC described it in a paper on accounting in hyperinflationary environments:
Financial statements unadjusted for inflation in most countries are prepared on the basis of historical cost without regard to
changes in the general level of prices. The individual assets, liabilities, shareholders’ equity, revenue, expenses and gains and
losses are therefore stated at cost at the time at which these items were originated. The impact of inflation is ignored. This
produces a meaningful result provided that there are no dramatic changes in the purchasing power of money. Significant changes in
the purchasing power of money mean that financial statements unadjusted for inflation are likely to be misleading. Amounts are
not comparable between periods, and the gain or loss in general purchasing power that arises in the reporting period is not
recorded. Financial statements unadjusted for inflation do not properly reflect the company’s position at the balance sheet date,
the results of its operations or cash flows. [2]
During periods of severe monetary inflation, such as during the 1970s in the United States, accounting standard-setting bodies
such as the Financial Accounting Standards Board have considered various new ways to present financial information. In the United
States, as in all low inflationary economies, financial information regarding historical cost items are not adjusted for
inflation.[3]
It is accepted in low inflationary economies that the historical cost model will undermine the accuracy of financial
statements whenever inflation is non-zero, which means always. When inflation is low or moderate however, the inaccuracy is
considered insufficiently important to warrant applying other methods. The IASB requires that hyperinflation accounting methods
be used whenever cumulative inflation over a three-year period is greater than 100%. This limit has been criticized as too high
and arbitrary.[4],[5]
Notes and references
- ^ Wolk, Harry I.; James L. Dodd
and Michael G. Tearney (2004). Accounting Theory: Conceptual Issues in a Political and Economic Environment, 6th ed.
South-Western, 133. ISBN 0324186231.
- ^ [http://www.pwc.com/gx/eng/about/svcs/corporatereporting/IAS29Publication06.pdf PriceWaterhouseCoopers, "Financial
Reporting in Hyperinflationary Environments: Understanding IAS 29, May 2006, p. 3
- ^ Wolk, Harry I.; James L. Dodd
and Michael G. Tearney (2004). Accounting Theory: Conceptual Issues in a Political and Economic Environment, 6th ed.
South-Western, 133. ISBN 0324186231.
- ^ [1] IAS 29 Financial Reporting in Hyperinflationary Economies
- ^ [http://newman.baruch.cuny.edu/DIGITAL/saxe/saxe_1975/kapnick_76.htm} Kapnick, H.,Value-Based Accounting - Saxe
Lectures (1975/76):
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