Historical cost means transactions are recorded at the cost when they occurred.
A basic principal of accounting is that resources are normally started in accounts at historical cost, i.e. at the amount which the business paid to acquire them. An important advantage of this procedure is that there is usually objective, documentary evidence to prove the amount paid to purchase an asset or pay an expense.
In general, accounts prefer to deal with costs, rather than with values. This is because valuations tend to vary according to what the valuation is for. For example, suppose that a company acquires a machine to manufacture its products. The machine has an expected useful life of four years. At the end of two years the company is preparing a balance sheet and has to decide what monetary amount to attribute to the asset.
Numerous possibilities might be considered,
- The original coat (historical cost) of the machine
- Half of the historical cost, on the ground that half of its useful life has expired
- The amount the machine might fetch on the secondhand market
- The amount it would cost to replace the machine with an identical machine
- The amount it would cost to replace the machine with a more modern machine incorporating the technological advances of the previous two years
- The machines economic value, i.e. the amount of the profits it is expected to generate for the company during its remaining life
All of these valuation have something to commend them, but the great advantage of the first two is that they are based on a figure (the machines historical cost) which is objectively verifiable. The subjective judgment involved in the other valuations. Particularly the last is so great as to lessen the reliability of any accounts in they are used.