The primary objective of reporting financial information to stakeholders is to provide useful data for decision-making. This information allows them to interpret a company’s activities and operations. Based on it, stakeholders can make various decisions regarding their relationship with the company. There are several tools that companies may use when reporting financial information. However, they must follow a standard body.
The contextual framework for financial reporting also dictates some aspects of the process. It sets out the information needed to assess various aspects. Similarly, it dictates the general purpose of financial reporting. While accounting standards apply to specific areas, this framework covers a broader area. In some cases, the contextual framework may conflict with accounting standards. In those cases, the latter takes precedence.
The conceptual framework also covers areas that may apply to every accounting standard. However, if a standard goes against it, the accounting standard will prevail. Nonetheless, the framework covers a broader range. One such area includes the measurement bases for various items in the financial statements. The framework provides several bases to measure those items. One of those consists of the historical cost basis.
What is Historical Cost?
Companies must measure various items in the balance sheet and other financial statements. Accounting standards permit multiple bases when establishing the value for those transactions. However, these standards do not mention the precise route for companies. Instead, it allows companies to choose the one that meets their specific needs. Among these, the most commonly used basis includes the historical cost method.
Historical cost refers to the amount of cash paid for an item. In accounting, some transactions may not involve cash at the time of the occurrence. Similarly, some may also require other forms of compensation. Therefore, historical cost refers to the amount of consideration given for an item. In accounting, most items follow the historical cost basis. Usually, it is the only reliable measure at the time of the transaction.
Historical cost also refers to the original cost of an asset. It is a primary feature of accounting and financial reporting. On top of that, it also conforms to the cost principle in accounting. This principle states that assets, liabilities and equity investments should be recorded at their original cost. In other words, it requires companies to use the historical cost method when measuring those items.
The historical cost also allows for flexibility when initially measuring an item. For assets, it usually includes the original cost. However, it can also let companies adjust for other expenses. For example, it may also consist of any expenditures incurred to get the asset to the position where it fits its intended purpose. This basis goes against other conventional bases, including the fair value basis.
Overall, historical cost measures the value of an item on the financial statements. This basis is prevalent in accounting when reporting. The historical cost method is common for fixed assets in the US under GAAP. However, it applies to more areas in IFRS, although there are other bases for measurement as well. Historical costs also differ from other applicable methods, although less common.
What are the other measurement bases?
Historical cost is the most commonly used basis for financial reporting. However, the contextual framework also specifies other methods that companies can use for that purpose. These bases provide different results when reporting items in the financial statements. On top of that, some of these methods may apply to specific cases rather than all reports.
Before understanding these bases, it is also crucial to consider accounting standards. Companies can only apply these bases for an item if the applicable standard allows it. If there are conflicts between the framework and those standards, the latter will prevail. Therefore, companies must always consider the specific standards before applying a measurement basis. If they fail to do so, it can create discrepancies in the reporting process.
Measurement basis can be challenging to understand. On top of that, companies must consider various factors before applying them. Nonetheless, they provide a viable alternative to the historical cost basis. An explanation of each of these bases is as follows.
Current cost
Current cost, also known as the replacement cost, is the most prevalent alternative to historical costs. It covers the cost that companies must pay to replace the asset at current values. One of the substantial benefits of the current cost basis is that it adjusts for inflation. However, it can be more challenging to update the items regularly.
Fair value
Fair value refers to the amount companies pay for an item in an ordinary transaction. However, this transaction must be at arm’s length. This basis allows companies to record assets at their market value. Fair value is also a prevalent basis in various accounting standards. Usually, companies use it as an alternative to the conventional historical cost basis. However, it can set off several complicated accounting procedures.
Present value
The conceptual framework also allows companies to record items at their present value. However, this basis applies to specific scenarios. On top of that, it is also the least commonly used basis among the ones listed here. Present value refers to the discounted value of future cash flows. Companies use this basis for items that involve cash flows receivable or payable in future periods.
Does IFRS use Historical Cost?
Historical cost is a common measurement basis under IFRS and GAAP. The former promotes this basis in various accounting standards. Usually, most assets under the IFRS use the historical basis for reporting. Companies must use the asset’s original cost to record it in the financial statements. Once they do so, the cost remains the same unless other standards apply. For example, depreciation and impairment may reduce them.
IFRS standards also require companies to consider the historical cost when initially measuring an item. As mentioned above, when a transaction occurs, other measurement bases may not be reliable. Similarly, the values under those bases may be the same as those under historical cost. Therefore, this basis provides a more reliable and accurate presentation of the underlying item.
Most accounting standards in IFRS promote the historical cost basis, particularly asset-based standards. However, some exceptions also accompany those standards. Under IFRS, companies can remeasure the value of property, plant and equipment at their fair values. However, this step is optional and at a company’s disposal. This option allows companies to use an alternative basis to the conventional historical cost approach.
Under the IFRS, most assets fall under the historical cost basis for measurement. However, some IFRS standards may include exceptions. For example, they consist of property, plant and equipment, biological assets, financial instruments, etc. Sometimes, the other measurement bases may provide more accurate or reliable results. For example, companies must record dismantling costs at the present value since it involves future cash flows.
Overall, IFRS uses historical costs more commonly. This basis applies to most standards that relate to assets. However, some exceptions may exist within those standards that allow for alternative treatments. For initial measurements, historical costs provide better and more reliable results. However, some companies may also prefer to report their assets at current values.
Conclusion
Historical cost refers to the original value of an asset. Similarly, it may include the price paid for an item when a transaction occurs. This basis is prevalent under accounting standards when reporting. However, companies may also use other methods, for example, current cost or fair value. IFRS uses historical costs for assets. However, some standards may also allow for alternative treatments, although optional.