In accounting historical cost concept dictates that entity must measure assets at their original cost incurred at the time of acquisition where cost is simply the cash value of resources given up (cash outflow occurred already) or promised to be given up (no cash outflow instead liability raised).
For the purpose of initial recognition, cost includes all the costs that are necessary to be incurred to bring the asset in the state of its intended use.
Accounting frameworks around the world favours historical cost concept for enhance financial information’s reliability and comparability. Reliability is increased as assets are measured exactly at the value of resources sacrificed by the entity at the time of acquisition. And as historical cost principle doesn’t allow for change in asset’s value due to market appreciation or decline, value of asset stays the same and helps in comparing financial statements over different periods.
Although over the period historical cost measurement may give different value of asset compared to current market value of similar assets, it is still preferred because of serious limitations of other measurement techniques. For example, for a used asset, computing market value is difficult as it is mostly done on the basis of similar asset in the market which is hard to find because every asset is used differently in different circumstances and therefore cannot be a true representative of every other asset in its class even of the same brand. To avoid complex estimation process, historical cost is used and asset is reduced on systematic basis using appropriate depreciation method.
In other words, even if asset’s value as per current market estimates is higher than its current book value, it will not be change and entity will continue with historical cost and left over balance after accumulated depreciation charge. The advocates of historical cost concept reinforce the idea saying that users can easily know for what amount asset was originally acquired years ago which is not possible if any other measurement technique is followed like current market value in which case original cost information will be lost.
However, where asset’s historical cost is significantly different from its current market value then accounting frameworks provide specific guidance on how to revalue the asset which is simply revision of the value of the asset.
One of the biggest factor in favour of historical cost is how cost-effective this method is. Entity simply has to carry the value that was paid to acquire the asset and does not have to involve in valuation process frequently. A trade-off considered that is considered worthwhile.
A building that was acquired for half a million few years ago has a current book value of 350,000. Current market value, however at the moment is exactly the same as it was at the time of acquisition. The asset will be carried at the book value for now instead of reinstating it to current market value.
Entity has 500 units of inventory that cost it 50,000 to make. It is expected that units will sell for a price much higher than cost. Although inventory can be sold for higher value, they will still be carried at cost without any appreciation recognized.
ABC is holding long-term investments. Since last two years, economy has experienced sharp inflation hike and prices are on the rise. The investment that cost ABC 100,000 is now valuing upwards of 200,000. Accountant is of the view that entity must take inflation in to account and appreciate the asset’s value.
ABC will continue to carry investment at original cost under historical cost concept unless an accounting standard requires revaluation after certain conditions are met. Mere inflation is not enough reason to change the value of asset.