When recording an asset in the financial statements, companies must have a value for it. However, it may not be as straightforward as there are several techniques to derive this cost. Most accounting principles rely on historical costs when recognizing various elements. However, some may also allow other methods, such as fair value or replacement cost.
However, companies cannot use all these valuation methods when acquiring an asset. It is of the requirements set forth under the historical cost principle. However, it is crucial to understand what the historical cost is first.
What is the Historical Cost?
Historical cost refers to the purchase price of an asset. It includes the acquisition, transport, installation, and other expenses in accounting. Essentially, any costs a company incurs in bringing a resource to its current and working condition will be a part of the historical cost. This cost does not change regardless of the asset’s fair or market value.
One of the primary reasons accounting standards rely on historical cost is that it is easy to derive. With the other costing methods for assets, determining the current value may be complex. On top of that, it can also lead to inaccurate information and over- or underestimating the cost. Therefore, historical cost provides more accurate and reliable information.
What is the Historical Cost Principle?
The historical cost principle requires companies to record an asset at its historical cost when initially recording it. This principle applies regardless of the accounting method used for assets. For example, some companies use the revaluation model of costing for assets. Under this method, a company evaluates an asset after regular intervals and records its fair value in the books.
However, the same does not apply when initially recording it. At the acquisition stage, the asset’s market value does not play a role in its value in the accounts. Companies must use an asset’s historical cost only when initially recognizing it. Usually, this value comes on the same time or date a company purchases or assumes ownership of the asset.
What is the importance of the Historical Cost Principle?
The importance of this principle links with the concept of historical cost. Essentially, historical cost provides a more reliable, verifiable, and accurate measure of an asset’s value. More specifically, it allows companies to gauge that value without complications. For any company, assets are one of the crucial elements of business and financial statements. Therefore, having a reliable measure for them is also critical.
The historical cost principle also allows users to evaluate a company reliably. On top of that, it also allows owners and shareholders to measure the current value of their business. Similarly, tax rules and regulations also rely on historical costs as they are more accurate than the fair value. Therefore, the historical cost principle helps companies and their stakeholders in various ways.
Conclusion
Historical cost refers to an asset’s initial purchase price plus any adjustments required by accounting standards. The historical cost principle requires companies to use this cost when initially recording an asset. Although other methods exist to evaluate assets, they only apply to a later stage. The historical cost principle helps bring accuracy to the balance sheet.
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