Question

The following note appears in the financial statements of a company: “The financial statements have been prepared on the historical cost basis, except for the measurement of certain financial instruments at fair value, and incorporate the principal accounting policies set out below” Please discuss in your own words your understanding of this statement in full. Provide examples to support your discussion.

Answer 1

Answer -

“The financial statements have been prepared on the historical cost basis, except for the measurement of certain financial instruments at fair value, and incorporate the principal accounting policies set out below”

Above statement is about the basis on which assets are valued in financial statement of company.

Below is the explanation of above statement-

Valuation of Assets at Historical Cost

Under this approach, assets are valued at original cost or acquisition cost, in other words when assets are valued at purchase cost.

For example a company purchased land and building at $ 1000,000 in 1976, in 2018 the same is value at $ 3000,000 in market. Even the price of assets is increased still it will be valued in financial statement at $ 1000,000. This accounting principal is known as valuing assets at historical cost. However it is also important to note that assets are shown at net asset value which is historical cost less accumulated depreciation.

Most of the assets are valued at the historical cost, with exception of few categories of assets like goodwill, marketable securities are valued on different basis.

Other valuation basis are as follows

1. Fair Market Value or Mark to Market is used for marketable securities like shares or trade receivables
2. Impairment of asset –such as goodwill
3. Replacement Value
4. Cost or fair value (whichever is less)   Inventory / stock

With respect to current practice followed in most of developed nations, historical cost valuation method is avoided and same is replace of replacement value principal. It is followed mainly for the assets which are to be replaced in future like plant and machinery.