The Framework of International Accounting Standards Board (IASB) defines historical cost as “A measurement basis according to which assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.”
Historical cost is a basis of measurement of elements of financial statements. Measurement is the process of determining the monetary amounts at which the elements of the financial statements are recognized and carried in the balance sheet and income statement. Usually four bases of measurement are used (1) Historical cost, (2) Current cost, (3) Realizable value, and (4) present value.
Historical cost is the most commonly used basis of measurement from these bases. It is usually used in combination with other measurement bases. For example, inventories are usually carried at the lower of cost and net realizable value, on the other hand marketable securities are usually carried at market value, and entities prefer to carry pension liabilities at their present value.
The drawback of historical cost accounting model is that it cannot deal with the effects of changing prices of non-monetary assets. Therefore some entities prefer to use current cost basis instead of historical cost accounting model.
The main advantage of using historical cost accounting model is its simplicity and certainty. Most entities know what they have paid for the assets when they purchased them. Similarly they also know what proceeds they received in exchange for their obligations. Historical cost method is a very objective method because usually subjective estimates are not involved.The most prominent disadvantage of this method is that book values may be based on badly out of date costs. This becomes more of a problem during periods of high inflation. Therefore, historical cost does not generally reflect current market valuation or fair value of an asset or liability.