The concept of the historical cost principle is that the assets are recorded based on the price at the time they are purchased, and the liabilities are recorded based on the values expected to pay at the original value rather than market value or inflation-adjusted value.
The Historical cost accounting principles are used mainly to record and measure the value of items in the balance sheet rather than items in the Income statements. This principle is used in both IFRS (the Principle Base) and US GAAP ( Rule Base).
Recognizing some items of assets or liabilities is required to record at the historical cost and the subsequent measure at the fair value.
However, some items require no change in their value subsequently.
It is incorrect to say that the historical cost accounting principle requires no change in the value of items in the Financial Statements.
Yet, it is the basis on which the value of the items is recorded at the historical cost.
We want to clarify this because some online resources stated that if the items are recorded at the historical cost, then the value of those items will not change subsequently.
This treatment is not correct.
Example of Historical Cost Principle:
For example, under the historical cost principle in IFRS, PPE per IFRS requires to record initially at cost, and the value will be reduced by depreciation or impairment.
The value of PPE is stated at the net book value or fair value after valuation.
Per US GAAP, the PPE is recorded at the historical cost and required to change the value in the financial statements even if the market value of assets increases or decreases.
For example, the Office Building of ACB Company was originally purchased for $500,000; ten years later, in 2016, the market value of the building is $1,500,000.
As per US GAAP, this building records $500,000 in its financial statements in 2016. The is no adjustment based on market Value required.
However, based on IFRS, Building was initially booked at its original cost and then depreciated based on its economic use or at the fair value per the revaluation model.
Advantages of Historical Cost Principle:
The advantage of the historical cost principle is that the users of financial statements could know exactly the original value of Assets or Liabilities in the financial statements as it requires no adjustments.
This accounting treatment is also less affected by accounting assumptions. Verifying the value of assets or liabilities based on a cost basis is much easier than market value.
It is a simple method that is easy to understand by management, accountant, and auditor.
The disadvantage of the Historical Cost Principle:
However, the Cost Accounting Concept does not reflect the current market’s real value of assets or liabilities. Using this concept, the users will get confused, especially when the market value of assets or liabilities is significantly different from the original costs.
For example, based on the cost model, the build is $500,000, but this building could be sold at $1,500,000. This sounds nonsense to the users.