The historical cost concept (also known as cost principle of accounting) states that the assets and liabilities of a business should be presented in accounting records at their historical cost.
Historical cost is the amount that is originally paid to acquire the asset and may be different from the current market value of the asset. Let us assume, for example, that a herbal medicine company purchases a piece of land for growing herbs on it, paying $25,000 in cash. The company will enter $25,000 as the cost of the land in its accounting records. In a booming real estate market, the fair market value of the land five years later might be $35,000. Although the market price of the land has significantly increased, the amount entered in the balance sheet and other accounting records would continue unchanged at the cost of $25,000.
A similar presentation is also required for liabilities. Companies issue various liabilities (such as accounts payable, bills payable, notes payable, bonds payable etc.) in exchange for goods and services. These liabilities are normally reported at their cost. For example, a company acquires a tract of land at an agreed price of $12,000 and issues a note payable amounting to $12,000 for the full payment. The cost of note payable to be entered in accounting records would be $12,000.
Importance of historical cost concept
An important advantage of historical cost concept is that the records kept on the basis of it are considered consistent, comparable, verifiable and reliable.
Any valuation basis other than historical cost may create serious issues for companies. For example, if a company uses current market value or sales value rather than historical cost, each member of accounting department is likely to suggest a different value for each asset of the company.
Further, current market or sales value is not appropriate for entities that prepare their financial statements more than once a year. For example, companies computing net income or preparing balance sheet on monthly basis would have to establish a new sales value for inventory and other assets at the end of each month which is usually inconvenient.
Exceptions to cost principle
When a company prepares its balance sheet, most of the assets are listed at their historical cost. However, some highly liquid assets are subject to exception of historical cost concept. For example, investments in debt or equity instruments of other enterprises that are expected to be converted into cash in near future are shown in the balance sheet at their current market value. Similarly, accounts receivable are presented in the balance sheet at their net realizable value. Net realizable value is the approximate amount of cash that a company expects to receive from receivables at the time of their collection.
The logic behind deviation of current market value and net realizable value from historical cost concept in reporting some liquid assets is to provide a more reliable information for predicting future cash inflows of the company and facilitating the users of financial statements in decision making.
Examples of historical cost concept or cost principle
- The Washington Company constructed a building at a cost of $45,000 in 2005. On December 31, 2017, the fair market value of the building is $65,000 but still stands on the balance sheet at its original cost of $45,000.
- The New York Company purchased a tract of land for $50,000 on January 1, 2010. Today the fair market value of the land is $65,000. Although the economic value or market price of the land has increased, the company would continue reporting it at its historical cost of $50,000.
- The Lasani Stone Crushing Company purchased a piece of equipment for $10,000 several years ago. Today, the worth of equipment is only $2,500 but the company would still report it at original cost less accumulated depreciation.
- Mexico Trading Company purchased 1,000 units of an item last quarter for $1 per unit . The current price of inventory is $1.25 per unit. The company would report inventory at purchase price of $1,000 and not at $1,250.