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Understanding the Historical Cost

On june 6, 2011, I published my written lecture on "Difference between the historical cost and fair value" in which I have explained historical cost.

Today, we are trying to explain historical cost more clearly to help you better understand the historical cost and how it helps you in decision making.

Original Cost of any asset or liability is called historical cost. Both assets and liabilities may have historical cost. There will not any changes in this cost when there will change in the market value of same asset or liability due to inflation or deflation. New accounting experts want to change the historical cost method for calculating the value of assets and liabilities but still it is being used for making balance sheet..

Now, we explain the historical cost of different assets :-


1. Historical Cost of Inventory

Historical cost of inventory means buying cost of inventory. As per rule, we calculate value of inventory on the basis of historical cost and market cost which ever will be less. For example, you are wholesaler  you had bought inventory at the cost of $ 100 but today, same inventory, you and other wholesaler are buying on $ 90. So, net realizable value is less than historical cost. So, we will calculate inventory at $90.

2. Historical Cost of Fixed Assets 

Historical cost of any fixed asset will be calculated with following formula.

Purchase price or construction Cost + Direct Expenses for bringing fixed asset in operation + Cost of borrowing to Finance the Same Asset buying or construction - Trade Discount 


3. Historical Cost of Liabilities 

Any loan or other liability which has been by us will be calculated on its historical cost. For example A gave Loan of $ 10,000 to B 5 years. Still B did not return his taken loan to A. Within 5 years, prices have increased almost double due to inflation but still loan cost will be $ 10,000 in both parties book.

Benefit of Historical Cost in Decision Making 

As investor, when you have to analyze the balance sheet for taking investment decision, you have to check every historical cost and try to convert it in fair value. With this, you can find real lose of any asset when we compare historical cost with current value. You can also recreate the balance sheet on the basis changes in price level if you get balance sheet on the basis of historical cost. On the other side, if you're using historical cost method for making balance sheet, you need not to record the gain before selling the asset because you have shown all assets in the book on the historical cost basis.

Thanks for joining us for learning this concept. We hope you found it useful, please feel free to share your thoughts and suggestions on our Accounting Education +page.

COMMENTS

: 1
  1. You have explained this concept in simple words, thank you. Kindly explain the concept of Reserve Capital.

    ReplyDelete
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Accounting Education: Understanding the Historical Cost
Understanding the Historical Cost
Accounting Education
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