Historical cost concept explained

The historical cost concept explains how accountants measure transactions. It explains that past costs should be used as the quantity for items in the financial statement. But not all transactions and line items in the FS rely on this principle. In this article, we explain it in detail.

1. What's historical cost concept

Historical cost concept is an accounting concept that explains the use of original cost to present items in the financial statements. For a FS to be deemed fairly presented and relevant, it must use monetary value in representing each line item in those reports. One method of going so is measuring some items by their original or historical cost.

Property, plants, and equipment are primarily presented at their original cost. However, if fair value must be used, the impairment gain or loss must be computed to reflect the changes. At times, historical cost can be referred to as carrying amount when the carried forward value is same as the original value of the asset.

2. Applying historical cost principle

The historical cost principle applies to PPE, expenses, and certain income. These costs can be the local currency or the converted foreign currencies value of the item. Also, the usage of it complies with the conservatism/prudence convention in accounting and the going concern concept explained earlier.

Prudence convention states that all expenses must be accounted for. And that it is better to understand the entity's profit than to overstate them. As a result, PPE are depreciated periodically to reflect their current value as well as ensuring that all expenses are matched with income. In the aspect of going concern, it is clearly stated that when it is sure that a business will remain for a long time, the transactions should be accounted for at their original value and not their liquidation value.

Furthermore, the money measurement concept explains that items in the FS should be measured in monetary terms. And that past cost model is one method of doing so. However, there are transactions you can't present at their original cost. Why? Doing so, will amount to not complying with the principle of fairness of presentation and relevancy.

For example, inventory is represented at either their historical cost or replacement value whichever is lower. Investments such as shares and debentures are measured at their fair value and not their original value. More so, if a firm owns foreign currencies, the value presented is based on their fair value.

3. Conclusion

As you have read, the historical cost concept stresses out the fact that data presented in the financial statement are based on past costs rather than future ones. Items in those statements are presented otherwise when it is more fairly and relevant to do so.