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Historical Cost Concept: Advantages & Disadvantages

Historical Cost Concept: Advantages & Disadvantages
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  • 0:00 Historical Cost Concept Use
  • 0:35 Some Advantages
  • 2:32 Some Disadvantages
  • 4:32 Lesson Summary
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Lesson Transcript
Instructor: Ryan Morales
The historical cost concept is a basic accounting concept. Read on to know more about the advantages and disadvantages of the historical cost concept in accounting.

Historical Cost Concept Use

Under the historical cost concept, assets are valuated at their original cost. If your company purchases land at $300,000, such asset will be initially recorded in your accounting books at the original cost or transaction price. Subsequently, at every reporting period, that land is reported and measured at the same amount in your company's balance sheet. Of course, we know that the value of land appreciates over time. However, we don't recognize increases and decreases in values under this concept of accounting.

Some Advantages

Let's look at some of the advantages of using the historical cost concept.

1. Objectivity and reliability of accounting information

The use of this concept maintains the objectivity of accounting information. The amounts in your financial statements are not clouded with subjective increases and decreases in values. There's no room for data manipulation because there is always an objective basis of recording business transactions. This cost concept also enhances reliability of accounting information. Reported amounts are easily verifiable. You can simply go back to the source documents of the business transactions, such as invoices, official receipts, contracts, work orders, etc., to verify the accuracy of the reported amounts in your financial statements.

2. Simplicity and convenience

This concept is basically simple. Transactions are recorded at their original amounts. You do not have to restate your financial statements every year to reflect the changes in values or the effect of changes in purchasing power of money and inflation. Consequently, you avoid the tedious process of restating amounts in your financial statements as well as the additional costs associated with asset revaluation, like the hiring of appraisers, etc.

3. Consistency and comparability of financial statements

When used consistently over time, this enhances intra- and inter-comparability of financial statements. Intra-comparability means that financial statements in each year of one entity are comparable to the financial statements of the previous years. This allows the entity to assess whether performance, financial position, and cash flows have improved or deteriorated over time. Inter-comparability means that financial statements of one entity are comparable to the financial statements of other entities. This allows the entity to benchmark and compare its performance, financial position, and cash flows versus competitors or industry leaders, for instance.

Some Disadvantages

Now let's take a look at some of the disadvantages of the historical cost concept.

1. Accuracy

The historical cost does not accurately represent the current market values of items in the financial statements. How sure are you that the land is still worth $300,000 today? Certainly, not! For one, there is the element of inflation. There is change in the purchasing power of the dollar. Also, there are changes in value because of the inherent nature of the asset. Land appreciates over time. An amount paid for legal expenses in January amounting to $1,000 will be recorded at that amount. However, you very well know that your attorney has raised his charges in November. How will you report this amount in your annual income statement? The historical amount is $1,000, but the value of legal services today has increased.

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