The concept of historical cost principle is that the assets are recorded base on the price at the time they are purchased. And the liabilities are recorded based on the values that 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 use in both IFRS (the Principle Base) and US GAAP ( Rule Base).
The recognition of some items of assets or liabilities is required to records 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 in which value of the items is recorded at the historical cost.
The reason we want to clarify this is that some online resource stated that if the items are records at the historical cost, then the value of those items will not change subsequently. This treatment is not correct.
Example of Historical Cost Principle:
The example of the historical cost principle in IFRS, PPE per IFRS requires to record initially at cost, and the value will be subsequently 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 require to change to the value in the financial statements even if the market value of assets is an increase or decrease.
For example, the Office Building of ACB Company was originally purchased for $500,000 and ten years later, in 2016, the market value of the building is $1,500,000. As per US GAAP, this building records at $500,000 in its financial statements 2016. The is no adjustment based on market Value required.
However, based on IFRS, Building was initially booked at its original cost and then depreciate based on its economic use or at the fair value as 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 also less affects by accounting assumption. Verifying the value of assets or liabilities base on a cost basis is much easier than market value, and it is a simple method which is easy to understand by management, accountant and auditor.
The disadvantage of Historical Cost Principle:
However, the Cost Accounting Concept does not reflect the real value of assets or liabilities in the current market. By using this concept, the users will get confusing especially when the market value of assets or liabilities are significantly different from original costs.
For example, base on the cost model, the build is $500,000, but this building could be sold at $1,500,000. This is sound nonsense to the users.