Historical cost
Encyclopedia
In accounting, historical costs is the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of acquisition. The balance sheet
value of the item may therefore differ from the "true" value.
While historical cost is criticised for its inaccuracy (deviation from "true" value), it remains in use in most accounting systems. Various corrections to historical cost are used, many of which require the use of management judgment and may be difficult to implement or verify. The trend in most accounting standards is a move to more accurate reflection of the fair or market value, although the historical cost principle remains in use, particularly for assets of little importance.
Depreciation
affects 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. Alternative measurement bases to the historical cost measurement basis, which may be applied for some types of assets for which market values are readily available, 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 variable real value non-monetary 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
.
The Constant Item Purchasing Power Accounting model is an International Accounting Standards Board
approved alternative basic accounting model to the traditional Historical Cost Accounting model.
Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.
For example –
At the end year 1 the asset is recorded in the balance sheet at cost of $100. No account is taken of the increase in value from $100 to $120 in year 1.
In year 2 the company records a sale of $115. The cost of sales is $100, being the historical cost of the asset. This gives rise to a profit of $15 which is wholly recognised in year 2.
(stock
) to a lower cost and net realisable value. As a result:-
includes:-
In IFRS, cost also includes the initial estimate of the costs of dismantling and removing the item and restoring it. Cost may include the cost of borrowing to finance construction if this policy is consistently adopted.
Cost is then subject to depreciation with to write off the cost of the asset over its estimated useful life down to the recoverable amount. In most cases the method is "straight line", with the same depreciation
charge from the date when an asset is brought into use until it is expected to be sold or no further economic benefits obtained from it, but other patterns of depreciation are used if assets are used proportionately more in some periods than others.
balances, receivables and payables which are denominated in foreign currency are reported using the closing exchange rate
under IFRS.
derivative
financial instruments
are stated at fair value (“mark to market
”) with movements recorded in the income statement
.
An entity operating in a hyperinflationary economy:-
there are a number of techniques used as alternatives to historical cost accounting including:-
The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CIPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
IAS8, 11:
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The CIPPA model is chosen by hardly any accountant in non-hyperinflationary economies even though it would maintain the real values of constant real value non-monetary items - e.g. issued share capital, retained income, other shareholder equity items, trade debtors, trade creditors, etc. for an unlimited period of time. This is because the CIPPA model is generally viewed by accountants as a 1970's failed inflation accounting
model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index
.
The IASB did not approve CIPPA in 1989 as an inflation accounting
model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc. to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc. are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
The IASB requires entities to implement IAS 29 which is a Constant Purchasing Power Accounting
model during hyperinflation.
Disadvantages
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
value of the item may therefore differ from the "true" value.
While historical cost is criticised for its inaccuracy (deviation from "true" value), it remains in use in most accounting systems. Various corrections to historical cost are used, many of which require the use of management judgment and may be difficult to implement or verify. The trend in most accounting standards is a move to more accurate reflection of the fair or market value, although the historical cost principle remains in use, particularly for assets of little importance.
Depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
affects the carrying value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
of an asset on the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
. 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
Cost basis
Basis , as used in United States tax law, is the original cost of property, adjusted for factors such as depreciation. When property is sold, the taxpayer pays/ taxes on a capital gain/ that equals the amount realized on the sale minus the sold property's basis.The taxpayer deserves a tax-free...
of an asset.
Historical cost does not generally reflect current market valuation. Alternative measurement bases to the historical cost measurement basis, which may be applied for some types of assets for which market values are readily available, 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 variable real value non-monetary 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
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
.
The Constant Item Purchasing Power Accounting model is an International Accounting Standards Board
International Accounting Standards Board
The International Accounting Standards Board is an independent, privately funded accounting standard-setter based in London, England.The IASB was founded on April 1, 2001 as the successor to the International Accounting Standards Committee...
approved alternative basic accounting model to the traditional Historical Cost Accounting model.
Historical cost basis (original cost)
Under the historical cost basis of accounting, assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values.Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.
For example –
- a company acquires an asset in year 1 for $100;
- the asset is still held at the end of year 1, when its market value is $120;
- the company sells the asset in year 2 for $115.
At the end year 1 the asset is recorded in the balance sheet at cost of $100. No account is taken of the increase in value from $100 to $120 in year 1.
In year 2 the company records a sale of $115. The cost of sales is $100, being the historical cost of the asset. This gives rise to a profit of $15 which is wholly recognised in year 2.
Inventory
It is standard under the historical cost basis to write down the value of inventoryInventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
(stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
) to a lower cost and net realisable value. As a result:-
- A downward movement in the realisable value of inventory below cost is recognised immediately
- An upward movement in the realisable value of inventory is not recognised until the inventory is sold
Property, plant and equipment
Property, plant and equipment is recorded at cost under the historical cost basis. CostCost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
includes:-
- Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates;
- Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating. These can include site preparation, delivery and handling costs, installation, assembly, testing, professional fees and the costs of employees directly involved in these activities.
In IFRS, cost also includes the initial estimate of the costs of dismantling and removing the item and restoring it. Cost may include the cost of borrowing to finance construction if this policy is consistently adopted.
Cost is then subject to depreciation with to write off the cost of the asset over its estimated useful life down to the recoverable amount. In most cases the method is "straight line", with the same depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
charge from the date when an asset is brought into use until it is expected to be sold or no further economic benefits obtained from it, but other patterns of depreciation are used if assets are used proportionately more in some periods than others.
Assets and liabilities denominated in foreign currency
Monetary items such as cashCash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
balances, receivables and payables which are denominated in foreign currency are reported using the closing exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
under IFRS.
Revaluation of property, plant and equipment
Under IFRS it is acceptable, but not required, to restate the values of property, plant and equipment to fair value. ‘Fair value’ is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Such a policy must be applied to all assets of a particular class. It would therefore be acceptable for an entity to revalue freehold properties every three years. The revaluations must be made with sufficient regularity to ensure that the carrying value does not differ materially from market value in subsequent years. A surplus on revaluation would be recorded as a reserve movement, not as income.Derivative financial instruments
Under IFRS and US GAAPGenerally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
derivative
Derivative
In calculus, a branch of mathematics, the derivative is a measure of how a function changes as its input changes. Loosely speaking, a derivative can be thought of as how much one quantity is changing in response to changes in some other quantity; for example, the derivative of the position of a...
financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
are stated at fair value (“mark to market
Mark to market
Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value...
”) with movements recorded in the income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
.
Financial reporting in hyperinflationary economies
IFRS requires a separate method of accounting in currencies deemed to be hyperinflationary. The characteristics of a hyperinflation include the population keeping its wealth in non-monetary assets or relatively stable foreign currencies, prices quoted in foreign currencies or widespread indexation of prices. This might arise if cumulative inflation reaches or exceeds 100% over three years.An entity operating in a hyperinflationary economy:-
- Records a gain or loss on its ‘net monetary position’ in its income statement.
- Records non-monetary items (for example, property, plant & equipment) in the balance sheet by applying indexation to their historical cost.
Management accounting techniques
In management accountingManagement accounting
Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control...
there are a number of techniques used as alternatives to historical cost accounting including:-
- measuring profit on sale of inventory by reference to its replacement cost. If inventory with a historical cost of $100 is sold for $115 when it costs $110 to replace it, the profit recorded would be $5 only based on replacement cost, not $15;
- charging economic rent for assets, particularly property. If a business uses a 20-year old property which it owns, depreciation on a historical cost basis might be insignificant. However, the management accounts could show a notional rent payable, being perhaps opportunity costOpportunity costOpportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...
- the amount the business could receive if it let the property to a third party.
IASB approved alternative to Historical Cost Accounting
The IASB's Framework introduced Constant Item Purchasing Power Accounting as an alternative to Historical Cost Accounting in 1989 in Par. 104 (a) where it states that financial capital maintenance - not variable real value non-monetary items, e.g. property, plant, equipment, inventory, intangible assets, etc., - can be measured in either nominal monetary units - the traditional HCA model - or in units of constant purchasing power: the CIPPA model.The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CIPPA model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board’s predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
“In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS8, 11:
“In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.”
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable.
The CIPPA model is chosen by hardly any accountant in non-hyperinflationary economies even though it would maintain the real values of constant real value non-monetary items - e.g. issued share capital, retained income, other shareholder equity items, trade debtors, trade creditors, etc. for an unlimited period of time. This is because the CIPPA model is generally viewed by accountants as a 1970's failed inflation accounting
Inflation accounting
Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. Inflation accounting is used in countries experiencing high inflation or hyperinflation...
model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
.
The IASB did not approve CIPPA in 1989 as an inflation accounting
Inflation accounting
Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. Inflation accounting is used in countries experiencing high inflation or hyperinflation...
model. CIPPA by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CIPPA only requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc. to be valued in units of constant purchasing power. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc. are valued in terms of IFRS and are not required in terms of the Framework, Par. 104 (a) to be valued in units of constant purchasing power.
The IASB requires entities to implement IAS 29 which is a Constant Purchasing Power Accounting
Constant Purchasing Power Accounting
Constant-purchasing-power accounting is:a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the...
model during hyperinflation.
Advantages and disadvantages of historical cost accounting
Advantages- Historical cost accounts are straightforward to produce
- Historical cost accounts do not record gains until they are realized
- Historical cost accounts are still used in most accounting systems
Disadvantages
- Historical cost accounts give no indication of current values of the assets of a business
- Historical cost accounts do not record the opportunity costs of the use of older assets, particularly property which may be recorded at a value based on costs incurred many years ago
- Historical cost accounts do not measure the loss of value of monetary assets as a result of inflation.
See also
- Constant Purchasing Power AccountingConstant Purchasing Power AccountingConstant-purchasing-power accounting is:a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the...
- Deprival valueDeprival valueDeprival valueis a concept used in accounting theory to determine the appropriate measurement basis for assets. It is an alternative to historical cost and fair value or mark to market accounting. Some writers prefer terms such as 'value to the owner' or 'value to the firm'...
- Fair value accounting
- InflationInflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...