Historical Cost

Background

Historical cost is a fundamental concept in accounting and economics. It refers to the accounting method in which assets are recorded at their original cost, the amount paid for them at the time of acquisition. This practice offers a clear and straightforward approach to valuing assets since it relies on actual market transactions that took place in the past.

Historical Context

The historical cost principle has long been a cornerstone of accounting practices. Its prominence grew as modern accounting systems developed in the 19th and early 20th centuries. This method gained favor due to its objectivity, as it is based on verifiable and unalterable cash transactions, making it a reliable source for financial statements. However, its relevance and adequacy have been subjects of debate, especially during periods of significant inflation.

Definitions and Concepts

Historical Cost Accounting: The practice of recording an asset on a balance sheet for the amount paid at the time of acquisition.
Depreciation Allowances: Reductions in the recorded value of an asset over time, accounting for wear and tear, technological changes, and other factors affecting the asset’s usefulness.
Replacement Cost: The cost to replace an asset at current market prices, in contrast to the original purchase price recorded under historical cost accounting.

Major Analytical Frameworks

Classical Economics

Classical economics predominantly focuses on market efficiency and equilibrium. Historical cost accounting is seen primarily as a neutral reporting method that does not inherently alter market dynamics.

Neoclassical Economics

Neoclassical economists emphasize the rational decision-making of firms and consumers. Historical cost data provide necessary but outdated information, potentially distorting decision-making if not adjusted for inflation and other market changes.

Keynesian Economics

Keynesian economists prioritize macroeconomic stability and policies tailored to manage economic cycles. They are concerned about how under-reported depreciation, as highlighted by historical cost accounting during inflationary periods, might misrepresent profit margins and thus influence fiscal and monetary policies.

Marxian Economics

From a Marxist perspective, historical cost accounting can obscure the true value relationships within capitalist production. The method underestimates the current reproduction costs of capital, potentially disguising the rate of exploitation and capital accumulation dynamics.

Institutional Economics

Institutional economists consider the historical cost approach within the broader context of institutional settings and historically grounded market transactions. They value the stability and comparability it offers but critique its rigidity in rapidly changing economic environments.

Behavioral Economics

Behavioral economists investigate how historical cost may affect investor and managerial behavior, noting that the anchoring effect might lead to decisions rooted in outdated valuations rather than current economic conditions.

Post-Keynesian Economics

Post-Keynesians are highly critical of historical cost accounting due to its inability to capture current market realities, especially under conditions of economic disequilibrium and inflation, leading to potentially misguided expectations and investment decisions.

Austrian Economics

Austrian economists favor market-based valuations and are critical of methods that seem detached from current market realities. They advocate for more dynamic accounting practices that reflect current value over historical cost.

Development Economics

Development economists focus on the impact of historical cost accounting in developing economies, where inflation is often a critical issue. The method’s underestimation of asset values can misinform policies and business strategies essential for economic progress.

Monetarism

Monetarists examine historical cost accounting in light of its implications for inflation measurement and monetary policy effectiveness. Underestimating asset values can contribute to skewed perceptions of profitability, complicating monetary policy decisions.

Comparative Analysis

The historical cost principle is often judged against fair value accounting, which records assets based on current market prices. Fair value offers more timely information, especially valuable in volatile economic climates, while historical cost provides stability and comparability across financial periods.

Case Studies

Hyperinflation in Zimbabwe: Analyzing how historical cost accounting inadequately reflected the true economic damage caused by hyperinflation.
The 2008 Financial Crisis: Exploring the reliance on historical cost and its impact on asset valuation within financial institutions.

Suggested Books for Further Studies

“Financial Shenanigans” by Howard Schilit
“Accounting for Growth” by Terry Smith
“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield

Fair Value: The estimated market price of an asset, reflecting current sale conditions agreed upon by a willing buyer and seller.
Inflation Accounting: Adjusting financial statements for inflation effects to reflect a more accurate financial position.
Capital Maintenance: An accounting principle where profit is measured based on the ability to maintain capital rather than merely retaining historical cost.
Current Cost Accounting: An accounting method where assets are reported based