The historical cost principle is a fundamental concept in accounting that helps businesses keep accurate records of their assets, liabilities, and equities. By recording the actual purchase price of an asset, this principle prevents overvaluation and allows for easier retrieval of pricing information. Read on to learn more about the historical cost principle and its role in accounting with Viindoo Enterprise Management Software.
What is Historical Cost principle?
Historical cost concept
The historical cost of an asset is the initial purchase or acquisition price. In accounting, it is necessary to record the actual acquisition costs of assets, liabilities, and equities in balance sheets. Regardless of any subsequent appreciation, the original price of the asset remains the same, and therefore, differs from its current market value.
Historical cost principle
Historical cost example
A historical cost principle example is when a company purchases a piece of equipment for $10,000. The equipment is recorded in the company's accounting system at its historical cost of $10,000. This means that the company will use the $10,000 as the basis for any subsequent accounting transactions involving the equipment, such as depreciation, repairs, or sale.
Assuming the equipment has a useful life of five years, the company will record annual depreciation expense of $2,000 ($10,000 divided by five years). This depreciation expense will be reflected in the company's income statement, reducing its net income for the year.
If the company decides to sell the equipment after three years of use, it will record the sale at its historical cost of $10,000, less accumulated depreciation of $6,000 ($2,000 per year times three years). The resulting book value of the equipment would be $4,000. If the company sells the equipment for $6,000, it will record a gain of $2,000 ($6,000 sales price less $4,000 book value).
Overall, the historical cost principle provides a reliable and objective measure of the value of the equipment, which is essential for accurate financial reporting.
Historical cost example
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FAQs about Historical Cost principle
Asset Impairment vs Historical Cost
The main benefit of using the historical cost principle in accounting is that it helps prevent overvaluing of assets. While appreciation is not taken into account, depreciation and amortization are accounted for.
If the recoverable value of an asset drops significantly and becomes worth less than its carrying value, it is considered impaired. In such cases, some assets can be reported at values lower than their historical cost. Normal wear and tear are typically recorded as annual depreciation, which is subtracted from the historical cost to calculate the asset's book value.
Fair Value vs Historical Cost
Historical cost and fair value are two concepts that relate to an object's original price and its changes over time. Historical cost represents an asset's actual purchase price, which is recorded on the balance sheet, while fair value is the asset's current market value.
The fair value principle, also referred to as mark-to-market practice, varies with market fluctuations. An asset's market value reflects the potential cash flow that could be generated in the future through prospective sales.
Therefore, the original price of an item can be used to assess and analyze its market performance. If the original price remains higher than the market value, this indicates that the market is moving downward, and vice versa.
How to use Historical Cost in Accounting
According to Generally Accepted Accounting Principles (GAAP), specific assets must be accounted for using the historical cost method. This method involves recording fixed assets at their original purchase price, while inventory is also typically recorded at historical cost. However, in some cases, inventory may be recorded at the lower of cost or market.
The historical cost is usually determined by calculating the cash or cash equivalent cost at the time of purchase. This amount includes the original purchase price of the asset as well as any additional expenses incurred to get the asset ready for use and in its proper place.
It can be seen that historical cost principle is a valuable tool for businesses to maintain accurate records of their financial transactions. While other valuation methods may consider current market value, historical cost remains a fundamental concept in accounting that ensures transparency and reliability in financial reporting. By adhering to this principle, businesses can make informed decisions and maintain a clear picture of their financial health.
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