Advantages of Historical Cost Accounting

Historical Cost Accounting is the concept which asset on balance sheet should record depend on price at the time of purchase. Historical cost is the cost of acquiring an asset which equals to an invoice bill or contract with the seller. These assets will be held at the original cost even their value increase significantly in the market over time. For example, the company purchased a plot of land that cost $ 50,000 in 1990 and this balance is recorded into the balance sheet. 30 years later, the same land has a market value of $ 500,000, we cannot increase land value to this amount. Even with the market price increase, the company must keep the initial cost, $ 50,000, on the balance sheet.

Moreover, the historical cost concept requires the company to record liability base on the original value rather than market value. Company usually has future obligations such as accounts payable, note payable, and bond payable. The company expects to settle this kind of liability base on the initial record.

Historical Cost Example

Company issue bond payable security which has a par value of  $ 1,000. Assume there is no discounted or premium value. So the company expects to pay bondholder $1,000 per bond even the market value of bond increase to $ 1,010.

On the balance sheet, we still record $1,000 per bond, there is no adjustment to bond value.

Advantages of Historical Cost Accounting

  • Easy: the company does not require to make evaluations on both assets and liabilities every accounting period to get the latest update. They simply record based on the initial cost.
  • Reliable: The record is more reliable as they are backed by strong supporting documents such as invoice and contract.
  • Comparable: It allows the user to compare one asset to another asset in the company or across the industry.
  • Prevent Financial Manipulation: Management may intend to overstate assets and understate liability. The market revaluation may become a good chance to do so as the process of revaluation is very subjective. It requires both judgment and assumption. However, historical costs prevent them from doing such things.
  • Easy to verify: External parties such as auditors can verify the cost of balance sheet easily. They just match them with supporting documents such as invoice & contract.
  • Easy to calculate depreciation expense: when fixed assets are recorded base on historical cost, it easy for accountants to calculate depreciation expense.

Disadvantages of Historical Cost Accounting

  • Not reflect with real value: The balance sheet still records the balance of land base on the initial cost which is ten times higher now. The true value of company is higher if we consider the fair value of assets when they are significantly increasing.
  • Easily manipulation on some ratios: some ratios rely on the balance of total asset such as return on asset (ROA), asset turn over and so on. By using historical cost, the asset balance is highly likely lower than the market price. The ratio will be higher as the total asset balance lower than the market value.