Accounting has many rules and regulations that companies must follow when recording and reporting financial information. Among these is the historical cost principle, one of the most important concepts that relates to a company’s financial statements. This principle requires a company to report the historical cost for specific assets, such as accounts receivable, inventory and property, plants, or equipment. The result is the original price paid for an item or the original monies expected for payment in terms of accounts receivable. Though the historical cost principle is among the most common accounting standards, it is not without its detractors.
The historical cost principle is the base of standard accounting practices in many cases. A company fills out its balance sheet with the items it owns and uses. These items fall under the asset section of the balance sheet. Each item here is recorded at its historical cost, so stakeholders know the monetary value of each item. The historical cost of items on the balance sheet offsets the value of liabilities and stockholders’ equity on the financial statement.
The two most common current assets recorded as historical cost are accounts receivable and inventory. Accounts receivable represents monies owed to the company by customers. The historical cost principle dictates that a company record each of these transactions as the actual amount of money owed. No changes or alterations are necessary to account for inflation; the values are in real terms. Inventory balances work in a very similar manner; the original amount paid is the value listed on the company’s balance sheet.
Long-term assets work in a similar manner in terms of the historical cost principle. The purchase price for each item — whether plant, property, or equipment — goes onto the balance sheet for the amount paid for by the company. Alterations for depreciation go in a separate contra account listed just below the corresponding asset account. This allows stakeholders to assess the actual book value of each asset. Not all assets have a corresponding contra asset; additionally, some companies may add together the asset account and contra asset account for financial reporting purposes.
A major drawback to the historical cost principle is the standard’s inability to reflect changes in the cost of replacement assets. For example, the historical cost is typically not what a company would pay to replace the item in a current market. Therefore, stakeholders may believe the company’s balance sheet to be understated. Or, a company’s assets may no longer be worth the historical value listed on the balance sheet. Therefore, the company’s balance sheet is overstated.