Historical Cost is the original cost incurred in the past to acquire an asset.
Historical Cost Convention requires assets to be recognized at their historical cost.
Assets need to be assigned some value in the accounting books.
Should assets be recognized at their historical cost, market value, replacement value or their potential business value? Historical Cost is clearly the most objective, reliable and verifiable value of the lot.
Historical Cost Convention requires assets to be recorded at their historical value unless it is prudent to recognize a lower value (e.g. due to impairment).
Historical Cost is therefore the default value assigned to assets.
A machine was acquired 5 years ago for $10,000.
New machine with the same specification would cost $40,000 today due to inflation.
The current market value of the machine in its present condition is $6,000.
Machine is depreciated using straight line basis over its useful life of 10 years.
Using the historical cost convention, what would be the net book value of the machine today?
Net book value = Cost - Accumulated Depreciation
= $10,000 - ($10,000 x 5/10)
The machine would be assigned a historical cost of $10,000. The replacement value (i.e. $40,000) and fair value (i.e. $6,000) would not be considered in the valuation.
Historical Cost Convention does not apply to certain types of assets such as financial instruments (e.g. cash, trade receivables, investment in shares).
Some assets that are generally valued at historical cost (e.g. property) may be valued according to a different basis (e.g. market value basis) if certain conditions are satisfied (e.g. market value of the assets could be determined reliably).
IFRS and GAAP provide specific guidance on the valuation of different types of assets.
Although the general theme of Historical Cost Convention is arguably present in the current accounting framework, it not explicitly recognized in IFRS and GAAP perhaps because distinct rules govern the valuation of different assets many of which are not valued at their historical cost.
The main limitation of historical cost is that of relevance.
Historical cost basis of accounting fails to account for the true economic cost of using assets. This effect of the use of historical cost basis is best explained by way of an example.
Company A purchased a plant for $100,000 on 1st January 2006 which had a useful life of 10 years.
Company B purchased a similar plant for $200,000 on 31st December 2010.
Depreciation is charged on straight line basis.
At the end of the reporting period at 31st December 2010, the balance sheet of Company B would show a fixed asset of $200,000 while A's financial statement would show an asset of $50,000 (net of depreciation).
The scenario above presents an accounting anomaly. Even though the plant presented in A's financial statements is capable of producing economic benefits worth 50% of Company B's asset, it is carried at a historical cost equivalent of just 25% of its value.
Moreover, the depreciation charged in A's financial statements (i.e. $10,000 p.a.) does not reflect the opportunity cost of the plant's use (i.e. $20,000 p.a.). As a result, over the course of the asset's life, an amount of $100,000 would be charged as depreciation in A's financial statements even though the cost of maintaining the productive capacity of its asset would have notably increased. If Company A were to distribute all profits as dividends, it will not have the resources sufficient to replace its existing plant at the end of its useful life. Therefore, the use of historical cost may result in reporting profits that are not sustainable in the long term.