An Introduction To Historical Cost

Introduction to historical cost

The sum total of all the expenses incurred on the assets by a company in acquiring it is known as the historical costs. These costs however are not very easy to measure. Imagine a company manufactures a machine for a special purpose in its own factory of producing its own products. This project from manufacturing to maintaining quality will require complete logistic support. In accounting the measure of value cost in balance sheets will reflect the nominal original cost at the time of acquirement by the company whereas the actual cost is very high. In the United States of America, Generally Accepted Accounting Principles (GAAP) supervises the historical cost methods used.

Measurement under historical cost basics

There are certain principals to be followed while measuring value under historical cost basis. Let us discuss basics of historical costs:

i. Inventory: The value of stock is written to a low and net realizable value under historical cost basis. As a result, the realizable value of stock below cost value showing downward movement is accepted right away. If the realizable value of stock above cost value showing an upward movement is shown then it is accepted after the stock is sold.

ii. Property, plant and equipment: Under the historical cost basis properties, plants and their equipments are recorded at par cost. The cost comprises of purchase price inclusive of import duties and taxes, less rebates and trade discounts. Other costs like transportation, handling costs, operational servicing and conditioning of the asset costs, installation, assembling and also payouts to employees directly involved are accounted for and included. Sometimes restoring, dismantling and removing, and finance borrowing costs are also included. This makes the cost subjected to depreciation in order to write off the value of the asset till it reaches to an amount which is recoverable.

iii. Assets and liabilities denominated in foreign currency: Under IFRS (International Finance Reporting Standards) anything to do with money like pay-ins and payouts, cash balances are all held in foreign currency and closing exchange rates are considered.

Exceptions to historical cost basics of accounting

There are many exceptions to historical cost basics of accounting which are discussed as:

a. Revaluation of property, plant and equipment: Values of properties, plants and equipments restated to a reasonable/fair value is acceptable by IFRS (International Financial Reporting Services) but not a requirement. An asset that can be exchanged or a liability that can be settled between two known parties willing to do so is the amount of ‘fair/reasonable value’. A particular class of assets must have such a policy applicable and every 3 years should revalue and accepted by all entities. This should be done on regular basis so that in consequent years the carrying and market value do not differ and a surplus on this revaluation should not be considered as an income but a reverse movement.

b. Derivative financial instruments: The fair value of derivative financial instrument’s movements must be recorded in income statement according to IFRS and US GAAP.

c. Financial reporting in hyper inflationary economies: In hyper inflationary economies, prescribed capital maintenance in units of constant purchasing power in currencies that are hyper inflationary, there is an IAS 29 Financial Reporting required by IFRS. I t means that population of such economies transform their wealth in non-monetary assets or a foreign currency that is much more stable. This means that the income statement shows profit or loss on its net monetary position and also non-monetary assets are enlisted in the balance sheet.

Conclusion

Historical cost is not efficient and has exceptions to it because it does not reflect current market value. It works best on individual basis and requires an alternative measurement base. This is the reason why International Accounting Standards Board (IASB) approved of ‘constant item purchasing power accounting’ model as an alternate to the Historic cost model.

This article has been compiled by sam g, who is an educational instructor.