The historical cost concept states that a business entity should identify the value of an item in terms of its historical cost in initial measurements. As a result, in every business transaction, the past or historical cost is recognized in the book of accounts rather than its future cost. In this article, we explained this term and its application to assets, liabilities, revenue, and expenses.
What you should know
The principle of historical cost applies primarily to non-current assets. It explains that these assets should be measured at their historical cost when it is initially recognized in the book of accounts. However, in the subsequent years, management can recognize it at cost or a revalued amount.
The revalued amount considers the fair value of the asset. According to the International Accounting Standards (IAS) 16, the fair value can either be higher or lower than the initial cost. If it is higher, a revaluation surplus exists, and a lower fair value means a revalued loss.
A company might decide to use the cost measurement basis; however, it will still be required to check for impairment and write off the impairment loss. Historical cost is not applied to property, plants, and equipment alone. Current assets, such as inventory, are valued at cost according to IAS 2. In addition, investment assets such as investment in subsidiaries are recorded at their initial valuation cost.
Uses of Historical Cost
It is used for initial measurements of assets. It can also be applied to liabilities, expenses, and revenue.
Expenses and Revenue applications
For revenue and expenses, their past costs are used. When goods are purchased on credit or cash, the amount recorded is the past cost, and that enters the statement of profit or loss. This is true with expenses such as electricity bills, salaries, and depreciation.
Revenue is also recognized at its historical selling price. Although the concept does not apply to revenue, the revenue value recorded in the goods is not future value rather the initial amount or cost at which the goods were sold.
Liabilities application
Liabilities are recorded at their principal amount in the statement of financial position. This is their historical value. And this amount is what is paid by the company along with the borrowing cost (interest) to the debtholder, though inflation may have reduced the principal.
The interest cost can also be regarded as past costs. Since they are predetermined when the debt amount is negotiated.
Other types of costs used in financial reporting
Aside from historical cost, accountants might use other types of costs. This depends on the conditions and events occurring in the organisation.
Breakup cost is used when a business is winding up. Here, a statement of affairs is prepared, and the assets and liabilities are valued at their disposal amount or breakup cost.
Future cost, on the other hand, applies when a business forecasts what it believes will be the cost of each item of income, expenses, liabilities, and assets. Mostly used in budgeting and financial modelling.
In conclusion, historical cost applies when a business is a going concern. It applies primarily to assets but the principle is also used for other classes of accounts. While there are other bases of cost in financial reporting, past cost remains widely used for business transactions.
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