Advantages and Disadvantages of Historical Cost Accounting

The historical cost accounting values an asset for balance sheet purposes at the price paid for the asset at the time of its acquisition.The historical cost accounting is the situation in which accountants record revenue, expenditure and asset acquisition and disposal at historical cost: that is, the actual amounts of money, or money’s worth, received or paid to complete the transaction.

Historical cost principle means that assets and liabilities are recorded at their actual historical cost. When an asset is written off, the loss is recorded as the historical cost of the asset less any accumulated depreciation. Typically, the asset would be fully depreciated and thus no loss recorded but this isn’t always the case. If the asset is sold the gain or loss is recorded as the amount received for the asset less the historical cost (net of any accumulated depreciation). In both cases, you’re using the historical cost as your basis in the asset, but in the write off, you didn’t receive anything in return for the asset. To record a sale, you must account for the payment you receive and that amount is of course, the current value of the asset – at least its value to someone (the purchaser).

Advantages and Disadvantages of Historical Cost Accounting

The historical cost is the cost at date of acquisition and when they incurred. The historical cost accounting concept requiring amount of all financial items recorded based upon original cost, even the items has increased in value due to inflation. It is the most commonly and widely used basis of financial reporting. While current value or fair value accounting concept is the concept that  financial items  be recorded at the realistic value at which they could be sold or settled as of the current date.

There are several merits or advantages of historical cost accounting concept. Firstly, it is easy to use and simple to apply as it is not required to reference to market values. Therefore, users no need to do market research to get the current price or market value of the financial items as the historical cost is not subjected to any future changes. They can just record down the original cost of the financial items in financial reports. Thus, the financial reports can certainly be prepared more speedily and easily than using other bases of measurement, which are current replacement cost, current market value and net realizable value, so it can contributes to cost savings and time savings.

Secondly, Historical cost accounting concept is easy to understand. In consequence of the simplicity of historical cost, users can easily understood and interpret financial reports well even though they do not have any financial background. Thirdly, Historical cost accounting concept is objective, verifiable and reliable. Since the historical cost is record based upon original amount paid, hence the original cost of the assets can confirmed through an original invoice or receipt.

Moreover, historical cost accounting concept also enables biz to keep track of their assets. Because the financial items are recorded in financial reporting based on the original cost of the items, therefore the users can compare the current cost and the original cost of the assets.

However, historical cost accounting concept also has shortcomings or disadvantages. Firstly, historical cost accounting concept is fixed, which means it is recorded based on the original cost in the invoice or receipt. Thus, it does not take inflation or changing prices into the account. During the inflation period, the price of the assets is different from changing a lots, it reflects large difference between original price and current price, so it does not seem sensible to record the value of assets by using the historical cost accounting concept when facing changing price.

Secondly, historical cost accounting concept does not show the true value of company’s assets. It recorded all the assets at the price at the date they are acquired.  It is unrealistic fixed assets values, which mean the balance sheet value of the financial assets are differ from the true value.

Thirdly, historical cost accounting concept is lead to the insufficient provision of depreciation. Depreciation is a mechanism of making funds for fixed assets replacement.    Depreciation is charged on original cost of the fixed assets in historical cost accounting concept, it is not charged at the price at which the same assets are acquired. Therefore, the provision of depreciation which is charged on the original cost will not be sufficient for the replacement of the assets.

Other than that, the disadvantages of historical cost accounting concept are unrealistic profit. Under historical cost accounting concept, financial reporting, such as Income statement does not show the true profit of the company as the revenues of the company are recorded on current price while the expenses are recorded at historical cost. So, it will lead to an overstatement of profit during the inflation period.