Historical Cost Concept: Definition & Examples

Instructor: Ryan Morales
In this lesson, you will learn about the historical cost concept, look at examples of its application, and familiarize yourself with arguments for and against its use in accounting.

Suppose you have a business and you purchased several acres of commercial land five years ago at $200,000. However, you very well know that the market value of that land has increased to $300,000 today. At what amount should you measure and report that asset in your balance sheet? Should it be at $200,000 or $300,000?

The short answer is: 'It depends.'

Historical Cost Concept Explained

In accounting, we may use four acceptable measurement bases. These are the historical cost, the current replacement cost, the net realizable value, and the present value.

Most financial statements primarily use the historical cost. Under the historical cost concept, business transactions are recorded in the accounting books at the transaction price--that is, their actual cost at the time the transaction took place. Consequently, income, expenses, assets, liabilities and equity items are reported in the financial statements at their original cost.

The historical cost concept is grounded on the going concern assumption of accounting. This assumption presupposes that the business will continue in the future unless it can be clearly inferred from circumstances that the business is a quitting concern. For example, imagine a certain company has suffered losses for several years already, its cash flows have been consistently negative, and it is very apparent that the company will shut down in a few years. This company will have to abandon the historical cost concept and may now report items in the financial statements at their current cost, rather than at the historical cost. This is because the users of financial information are no longer concerned with objective and verifiable information. At the moment, they are more concerned with how much they could possibly get in the event of liquidation.

Examples of Historical Cost Concept

Under the historical cost concept, the commercial land purchased five years ago at $200,000 will have to be reported in your company's balance sheet at $200,000.

A certain item for sale will be reported as part of your inventory at its actual historical cost of $100 even though its replacement cost has actually increased to $120.

A sale made in January this year for a total amount of $40,000 will have to be reported in your annual income statement at the $40,000 transaction price even though you actually increased your selling prices towards the end of the year.

An advertising expense for a newspaper ad in January at $900 will have to be reported at that amount in your annual income statement even if your supplier has actually changed ad rates sometime during the year.

Why and Why Not to Use Historical Cost

Advocates of the historical cost principle say that this measurement basis is objective and easily verifiable. We can always go back to the source documents of the transactions--suppliers' invoices, official receipts, work orders, etc. to verify amounts recorded in the accounting books. Also, when used consistently, the use of historical cost promotes comparability of financial statements.

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