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In
accounting Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compare with other ob ...
, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting involves reporting
asset In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s and liabilities at their historical costs, which are not updated for changes in the items' values. Consequently, the amounts reported for these
balance sheet In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such ...

balance sheet
items often differ from their current economic or market values. While use of historical cost measurement is criticised for its lack of timely reporting of value changes, it remains in use in most accounting systems during periods of low and high
inflation In economics, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a r ...

inflation
and
deflation In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behav ...

deflation
. During
hyperinflation In economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of pl ...

hyperinflation
,
International Financial Reporting Standards International Financial Reporting Standards, commonly called IFRS, are accounting standard Publicly traded companies typically are subject to the most rigorous standards. Small and midsized businesses often follow more simplified standards, plus ...
(IFRS) require
financial capital Financial capital (also simply known as capital or equity in finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contra ...
maintenance in units of constant purchasing power in terms of the monthly
CPI#REDIRECT consumer price index#REDIRECT consumer price index A consumer price index measures changes in the price level of a weighted average market basket of Goods, consumer goods and Services marketing, services purchased by households. A CPI ...
as set out in IAS 29, Financial Reporting in Hyperinflationary Economies. Various adjustments to historical cost are used, many of which require the use of management judgment and may be difficult to verify. The trend in most accounting standards is towards more timely reflection of the fair or market value of some assets and liabilities, although the historical cost principle remains in use. Many accounting standards require disclosure of current values for certain assets and liabilities in the footnotes to the financial statements instead of reporting them on the balance sheet. For some types of assets with readily available market values, standards require that the carrying value of an asset (or liability) be updated to the market price or some other estimate of value that approximates current value (fair value, also
fair market value The fair market value of property is the price at which it would change hands between a willing and informed buyer and seller. The term is used throughout the Internal Revenue Code The Internal Revenue Code (IRC), formally the Internal Revenue Code ...
). Accounting standards vary as to how the resultant change in value of an asset or liability is recorded; it may be included in income or as a direct change to shareholders'
equity Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the differe ...
. The capital maintenance in units of constant purchasing power model is an
International Accounting Standards Board The International Accounting Standards Board (IASB) is the independent, accounting standard Publicly traded companies typically are subject to the most rigorous standards. Small and midsized businesses often follow more simplified standards, plus ...
approved alternative basic accounting model to the traditional historical cost accounting model.


Historical cost basis (original cost)

Under the historical cost basis of accounting, assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values. Costs recorded in the
Income Statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statemen ...
are based on the historical cost of items sold or used, rather than their replacement costs. For example, * a company acquires an asset in year 1 for $100 * the asset is still held at the end of year 1, when its market value is $120 * the company sells the asset in year 2 for $115 At the end year 1 the asset is recorded in the balance sheet at cost of $100. No account is taken of the increase in value from $100 to $120 in year 1. In year 2 the company records a sale of $115. The cost of sales is $100, being the historical cost of the asset. This gives rise to a gain of $15 which is wholly recognized in year 2.


Measurement under the historical cost basis


Inventory

It is standard under the historical cost basis to report the cost of
inventory Inventory (American English American English (AmE, AE, AmEng, USEng, en-US), sometimes called United States English or U.S. English, is the set of varieties of the English language native to the United States. Currently, American English ...
(
stock In finance, stock (also capital stock) consists of all of the shares In financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities i ...

stock
) at the lower of cost and
net realisable value Net realizable value (NRV) is a measure of a fixed or current asset's worth when held in inventory, in the field of accounting. NRV is part of the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) ...
. As a result:- * A decrease in the realisable value of inventory to an amount below its historical cost is recognised immediately * An increase in the realisable value of inventory is not recognised until the inventory is sold.


Property, plant and equipment

Property, plant and equipment Fixed assets, also known as long-lived assets, tangible assets or property, plant and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. Fixed assets are different than current assets ...
is recorded at its historical cost.
Cost In production Production may be: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production ...

Cost
includes:- * Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; * Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating. These can include site preparation, delivery and handling costs, installation, assembly, testing, professional fees and the costs of employees directly involved in these activities. In
IFRS International Financial Reporting Standards, commonly called IFRS, are accounting standard Publicly traded companies typically are subject to the most rigorous standards. Small and midsized businesses often follow more simplified standards, plus a ...
, cost also includes the initial estimate of the costs of dismantling and removing the item and restoring it. Cost may include the cost of borrowing to finance construction if this policy is consistently adopted. The historical cost is then depreciated: it is systematically reduced to the recoverable amount, over the estimated useful life of the asset, to reflect the asset's usage. The depreciation (reduction of historical cost) is charged to expense. In most cases the "straight line" depreciation method is used, resulting in the same
depreciation In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the allocation in a ...

depreciation
charge each year until it is expected to be sold or no further economic benefits obtained from it. Other patterns of depreciation are used if assets are used proportionately more in some periods than others.


Financial instruments

Certain financial items may be recorded at historical cost which is the basic method of
financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporat ...
. Any initial issue premium or discount is amortized to interest over time, and the resulting value is often described as amortized cost.


Exceptions to the historical cost basis of accounting


Revaluation of property, plant and equipment

Under IFRS it is acceptable, but not required, to re-measure the values of property, plant and equipment at their fair (current) values. 'Fair value' is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Such a policy must be applied to all assets of a particular class. It would therefore be acceptable for an entity to revalue freehold properties every three years. The revaluations must be made with sufficient regularity to ensure that the carrying value does not differ materially from market value in subsequent years. A surplus on revaluation would be recorded as a reserve movement, not as income.


Derivative financial instruments

Under
IFRS International Financial Reporting Standards, commonly called IFRS, are accounting standard Publicly traded companies typically are subject to the most rigorous standards. Small and midsized businesses often follow more simplified standards, plus a ...
and US GAAP
derivative In mathematics Mathematics (from Greek: ) includes the study of such topics as numbers (arithmetic and number theory), formulas and related structures (algebra), shapes and spaces in which they are contained (geometry), and quantities ...
financial instrument Financial instruments are monetary contracts A contract is a legally binding document between at least two parties that defines and governs the rights and duties of the parties to an agreement. A contract is legally enforceable because it me ...
s are reported at fair value, with value changes recorded in the
income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statemen ...
.


Financial reporting in hyperinflationary economies

IFRS requires IAS 29 Financial Reporting in Hyperinflationary Economies which prescribes capital maintenance in units of constant purchasing power in currencies deemed to be hyperinflationary. The characteristics of a hyperinflation include the population keeping its wealth in non-monetary assets or relatively stable foreign currencies, prices quoted in foreign currencies or widespread indexation of prices. This might arise if cumulative inflation reaches or exceeds 100% over three years. An entity operating in a hyperinflationary economy:- * Records a gain or loss on its 'net monetary position' in its income statement. * Records non-monetary items (for example, property, plant & equipment) in the balance sheet by applying indexation to their historical cost.


Management accounting techniques

In
management accounting In management accounting or managerial accounting, managers use accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
there are a number of techniques used as alternatives to historical cost accounting, including:- * measuring profit on sale of inventory by reference to its replacement cost. If inventory with a historical cost of $100 is sold for $115 when it costs $110 to replace it, the profit recorded would be $5 only based on replacement cost, not $15; * charging economic rent for assets, particularly property. If a business uses a 20-year-old property which it owns, depreciation on a historical cost basis might be insignificant. However, the management accounts could show a notional rent payable, being perhaps
opportunity cost In microeconomic theory Microeconomics (from Greek prefix ''mikro-'' meaning "small" + ''economics'') is a branch of economics Economics () is the social science that studies how people interact with value; in particular, the Produ ...
- the amount the business could receive if it let the property to a third party.


IASB approved alternative to historical cost accounting

The IASB's Framework introduced Capital Maintenance in Units of Constant Purchasing Power as an alternative to Historical Cost Accounting in 1989 in Par. 104 (a) where it states that financial capital maintenance can be measured in either nominal monetary units - the traditional HCA model - or in units of constant purchasing power at all levels of inflation and deflation: the CMUCPP model. The specific choice of measuring financial capital maintenance in units of constant purchasing power (the CMUCPP model) at all levels of inflation and deflation as contained in the Framework for the Preparation and Presentation of Financial Statements, was approved by the International Accounting Standards Board's predecessor body, the International Accounting Standards Committee Board, in April 1989 for publication in July 1989 and adopted by the IASB in April 2001.
"In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8."
IAS Plus, Deloitte
/ref> IAS8, 11:
"In making the judgement, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework."
There is no applicable International Financial Reporting Standard or Interpretation regarding the valuation of constant real value non-monetary items, e.g. issued share capital, retained earnings, capital reserves, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all other non-monetary receivables and payables, Profit and Loss account items such as salaries, wages, rents, etc. The Framework is thus applicable. The CMUCPP model is chosen by hardly any accountant in non-hyperinflationary economies even though it would automatically maintain the real value of constant real value non-monetary items, e.g. issued share capital, retained income, other shareholder equity items, trade debtors, trade creditors, etc., constant for an unlimited period of time in all entities that at least in real value at all levels of inflation and deflation - all else being equal. This is because the CMUCPP model is generally viewed by accountants as a 1970s failed
inflation accounting Inflation accounting comprises a range of accounting models designed to correct problems arising from historical cost In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting i ...
model that requires all non-monetary items - variable real value non-monetary items and constant real value non-monetary items - to be inflation-adjusted by means of the
Consumer Price Index#REDIRECT consumer price index A consumer price index measures changes in the price level of a weighted average market basket of Goods, consumer goods and Services marketing, services purchased by households. A CPI is a statistical estimate con ...
. The IASB did not approve CMUCPP in 1989 as an
inflation accounting Inflation accounting comprises a range of accounting models designed to correct problems arising from historical cost In accounting, an economic item's historical cost is the original nominal monetary value of that item. Historical cost accounting i ...
model. CMUCPP by measuring financial capital maintenance in units of constant purchasing power incorporates an alternative capital concept, financial capital maintenance concept and profit determination concept to the Historical Cost capital concept, financial capital maintenance concept and profit determination concept. CMUCPP requires all constant real value non-monetary items, e.g. issued share capital, retained income, all other items in Shareholders Equity, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, all items in the profit and loss account, etc. to be valued in units of constant purchasing power on a daily basis. Variable real value non-monetary items, e.g. property, plant, equipment, listed and unlisted shares, inventory, etc. are valued in terms of IFRS and updated daily. The IASB requires entities to implement IAS 29 which is a Capital Maintenance in Units of Constant Purchasing Power model during hyperinflation.


Advantages and disadvantages of historical cost accounting

Advantages * Historical cost accounts are straightforward to produce * Historical cost accounts do not record gains until they are realized * Historical cost accounts are still used in most accounting systems Disadvantages * Historical cost accounts give no indication of current values of the assets of a business * Historical cost accounts do not record the opportunity costs of the use of older assets, particularly property which may be recorded at a value based on costs incurred many years ago * Historical cost accounts do not report/account the loss of real value of nominal monetary items as a result of inflation or the gain in real value in nominal monetary items during deflation., page 3.


See also

*
Constant Purchasing Power Accounting Constant purchasing power accounting (CPPA) is an accounting model approved by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) as an alternative to traditional historical cost accounting un ...
* Deprival value *
Fair market value The fair market value of property is the price at which it would change hands between a willing and informed buyer and seller. The term is used throughout the Internal Revenue Code The Internal Revenue Code (IRC), formally the Internal Revenue Code ...
*
Inflation In economics, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a r ...

Inflation


References

{{Authority control Costs Accounting terminology