Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.
Historical Cost: Definition, Principle & Advantages
Historical Costs: A Real-Life Scenario
Imagine you are a farmer. One day, you look at all of the farmland you own and realize that two of your acres are no longer needed. They simply do not produce the crops you had expected. You then decide it is time to think about selling those two acres. In order to determine what to sell the land for, you pull up the bill of sale to look at the price you originally paid for the acres. What you are determining is the historical cost.
Historical Costs Defined
Historical cost is a term used in accounting that represents the original cost of an asset you've acquired or purchased at the time of transfer or sale. In cost accounting, the term refers to an amount of money used to buy or run a business.
It is important to understand that historical cost and cost are often used interchangeably during a transaction. Additionally, the term historical cost is used when trying to differentiate original costs from replacement or current costs. For example, if you purchased land in the year 2000 for $10,000, in 2015, the historical costs will still be $10,000, despite the fact that the price of land may have increased over time. Lastly, historical cost does not take into account the effects of inflation.
Principle of Historical Cost
Next, let's take a look of the principle of historical cost, in which the definition of the term is applied to a business or firm. For example, when business owners fill out a balance sheet, they need to report the historical cost at the time of the transaction, and not the current or replacement costs. While some countries, such as the Netherlands and the United Kingdom, may allow historical cost figures to be modified in accordance with economic, inflationary or market changes, this practice is not allowed in the United States.
While historical costs are always factual or reliable, they are not always useful. For example, the figures do not provide information about the current value is of an asset, which can be more readily determined through fair market value.
Advantages of Historical Cost
Now, let's identify the advantages of historical costs: reliability and verification.
- Reliability: A company can easily look at what they paid for the item at the time of a transaction. However, determining the current price is much more difficult. It often requires an evaluation, which can be biased.
- Verification: Because the cost of an asset at the time of transaction is usually documented, the historical costs can be verified. For example, a business can look at invoices and contracts.
Historical costs and costs, are often interchangeable. Both of these terms are used to describe the costs of an asset at the time the asset is purchased or acquired. When businesses complete financial records, they often refer back to the principle of historical cost in order to determine what they paid for an asset. Because historical cost can be verified and is reliable, it is often used because of its advantages.
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