Accounting transactions are recorded on the date when they incur. So, they remain reflected on the value at which we have recorded them. So, a transaction recorded for sales revenue in the last 5 years ago will stay be there as it is. This is the historical cost concept of accounting. In accounting, we cannot update the historical figures unless and until required by the accounting standard.
Example
- Alpha Industry purchased raw materials costing $5 per unit. After 30 days, the price of raw material has increased to $8 per unit. Alpha will not take into account any rise in price after the date of purchasing the raw material over the historical cost concept.
- Gamma Company purchased a car at a price of $5 millions. After the year, the price of the car increased to $6 million. Gamma will continue to record the car at $5 million minus any accumulated depreciation in the balance sheet irrespective of any rise in the market value of the car.
Example
Logi is involved in logistic business since 50 years. During this period, it has earned a good reputation in the industry and is counted in Top 5 companies of the industry. One of your junior needs some clarification on how to treat the following information / transaction into the books of accounts.
- The warehouse land which Logi purchased 50 years ago at $100,000 now has a market value of $5,000,000.
- The equipment purchased for packaging 08 years back at a cost of $20,000 now has market value of just $2,000.
- Inventory of papers purchased 06 months ago at $1 per unit, now has market value of $ 1.10.
Required
As a senior management accountant, you are requested to advise the accountant on the treatment of above information / transactions.
Solution
In order to account for transactions, we need to follow some accounting principles such as historical cost principle. We look at each and every case one by one as follows:
- Though, the land value today is much higher than its historical price, but Logi has to record the land at the historical cost to obey the historical cost principle.
- The equipment is a fixed asset and every year, its value diminishes due to application of depreciation. The market value of the asset is ignored. So, at the balance sheet, equipment will be disclosed at the historical cost minus value of ac cumulated depreciation.
- Though, the inventory market value has increased, still Logi will report the inventories at $1 per unit to comply with the historical cost principle.
Apparently, it looks that we are reporting assets at lower value and as a result, are presenting the lower value of the company. On the other hand, historical cost principle helps us greatly in making our financial statements comparable and match able between various accounting periods and within the industry’s competitors. This way, investors and other stakeholders make well informed decisions.