The historical cost of an asset is the amount paid for it and the historical cost of a liability is the amount received in respect of it or the amount expected to be paid to satisfy it.
Historical cost accounting is interpreted to require that the amount at which an asset is stated in the accounts should not exceed the amount expected to be recovered from either its use or its sale (its recoverable amount). Historical cost as it is understood is therefore recoverable historical cost.
Recoverable amount is usually considered to be the higher of an asset’s realisable value and its value in use. The resulting recoverable historical cost tree for determining an asset’s recoverable historical cost is summarised below:
For an item of stock (or inventory), value in use is not normally relevant, so the usual formula is the lower of historical cost and net realisable value. For a fixed asset in profitable use, net realisable value is not normally relevant, so the usual question is: which is the lower of historical cost and value in use? Sometimes fair value is used instead of either recoverable amount or one of its elements.
Under historical cost accounting, where an asset increases in value above its historical cost amount, the gain is not recognised until it is realised. Unrealised gains are excluded from income and from the balance sheet. The recognition of gains is therefore to some extent under the control of management, which can decide when assets are realised and so when any related gains are recognised. But also this measurement basis remains popular because of the relative low risk of high valuation or even manipulation.
Many intangible assets are not recognised under historical cost accounting because their capacity to generate future revenue is too uncertain at the time their costs are incurred for them to qualify as assets.
In terms of income measurement, the objective of historical cost is to match costs as they are incurred with income as it is realised (matching principle). The cost of a fixed asset is therefore written off over its expected useful life, and the measurement shown in a balance sheet represents costs incurred that will be written off against the future income they are expected to help generate.
Why we like historical cost measurement?
Historical costs can usually be measured reliably when they are taken from prices in actual transactions. For example, the original purchase price of a fixed asset or an item of stock (or inventory) may be clearly identifiable, and amounts received (giving a measurement of a liability) and amounts owed to the business (debtors) may also be objectively measurable.
Why we object historical cost measurement?
Many subjectivities in historical cost arise from the fundamental problems of prediction and allocation to periods and assets – for example, in relation to depreciation, the cost of self-produced assets, the estimation of recoverable amounts, and liabilities for future costs (disposal, environment).
Why is historical cost measurement still relevant?
Information prepared on a historical cost basis might be more relevant for some purposes than information prepared on other bases. For example, because it does not recognise unrealised gains on assets, historical cost is more conservative than any of the current value bases and this may appeal to some users.
- Lenders and other creditors may consider that their interests are better protected if net assets are measured conservatively, as this reduces the extent to which the company’s assets can be paid out as dividends. They may regard the distribution of unrealised gains, which historical cost avoids, as especially risky. Shareholders also gain to the extent that it is therefore easier for the business to raise loans and other credit.
- Where managers are rewarded on the basis of reported profit, investors may prefer it to be measured with caution. If profits subsequently prove to be overstated, investors are unlikely to be able to get the company’s money back from its managers.
Other important characteristics of historical cost information that may appeal to some users are that:
- Its fundamental approach of comparing costs incurred with income realised seems to some users to match a fundamental objective of business.
- For most businesses, it is more likely than other measurement bases to match the information that management uses.
What do we hold against historical cost measurement?
Critics of historical cost argue that its measurements:
- are inherently irrelevant to any contemporary decision because they are out-of-date information and provide no guide to an entity’s current financial position;
- typically ignore internally generated intangibles, which are increasingly critical to businesses, as well as financial instruments that have no (or marginal) cost; and
- fail to take into account unrealised gains, and may therefore significantly understate both net assets and income or allocate income to particular years on grounds (realisation) that should be irrelevant to its measurement.