Historical cost plays an important role in ensuring conservative financial reporting practices.
“Accounting conservatism is a set of bookkeeping guidelines that call for a high degree of verification before a company can make a legal claim to any profit.”
While the concept of historical cost is fairly simple, it is behind many of the valuation policies that businesses must adhere to and plays a critical role in tax accounting.
Understanding the concept of historical cost will help you to develop a more robust approach to interpreting your business’s financial reports.
In this post, we’ll cover what historical cost is, how it impacts your financial reporting, and how the concept of historical cost has both positive and negative characteristics.
What Is Historical Cost?
The term is used to describe the actual and original cost of an asset. It is also used as a required valuation policy under the United States Generally Accepted Accounting Principles (US GAAP).
The historical cost concept uses the original cost basis of an asset as its carrying value on the balance sheet. The concept is a product of the cost principle, which requires businesses to record an asset, liability, or equity contribution at its original cost at the time it was acquired.
Historical cost has other applications in the various fields within accounting. For example, real estate accountants take great care in maintaining an accurate record of a property’s cost basis.
This has an impact on both tax reporting and financial reporting. Tax accountants also pay close attention to how businesses record the cost basis of an asset.
Impacts Of Historical Cost On Financial Reporting
As we covered in the previous section, the historical cost of an asset is used as its carrying value on the balance sheet. However, the assets that are recorded at their historical cost typically require some adjustments over time.
These adjustments are usually the result of depreciation expense, which is common with longer-term assets.
This means that the actual balance reflected for an asset will typically be its depreciation-adjusted historical cost. Also, if the assets’ value ever becomes less than the historical cost, then the cost-basis must be adjusted to reflect the impairment.
It is important to note that the cost principle, does not typically apply to long-term assets and liabilities.
Pros and Cons Of Historical Cost Accounting
Like most accounting policies, there are pros and cons to the concept of historical cost. In all cases, this is likely a result of balancing the need for fair and accurate reporting against the concept of conservatism.
Pros of historical cost basis accounting are:
● The cost basis is easily proven, often backed by source documents
● Considered to be excessively conservative
● Easy-to-understand and interpret
● Accurate record keeping of historical cost plays an important role in developing well-informed tax strategies
One of the biggest benefits of the historical cost concept is that it is relatively easy to understand. This means that the concept is easily applied through a variety of industries and makes it simple for a less sophisticated audience to grasp. Another positive side-effect of historical cost reporting is how conservative it is.
This means that the value reported on the balance sheet is always well below its fair value. Ironically, this is also one of its main drawbacks. One argument in support of historical cost is that its conservative nature paints the most financially solvent picture.
Drawbacks and criticism of historical cost basis accounting are:
● Does not represent the fair value (market value) of an asset
● Could significantly undervalue a businesses assets
● Disproportionately impacts long-term assets (and liabilities)
Because historical cost does not typically apply to long-term assets and liabilities it creates a bigger chance that balance sheets that are heavily weighted towards them might not be an accurate depiction of value.
Regardless of its use as a tool for valuation, keeping accurate records of historical cost plays a crucial role in sophisticated tax planning and institutional financing. Historical cost, like many accounting policies, is an equilibrium of criticisms and justifications.
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