Accounting Principles

The Historical Cost Concept Accounting Principle

Imagine, for a moment, trying to read a financial statement that had listed assets such as: cash $5,000; 14 boxes of oranges; 25 boxes of apples; 1000 board feet of lumber; 3 acres of land; and, 8 machines. A first question that might pop into your mind is: “How in the world do I add these assets to one another?”
It is immediately clear that for financial statements to be meaningful, amounts of dissimilar items must be stated in similar units. Money becomes the obvious choice of “similar units”. By converting different kinds of objects into monetary amounts, they can be dealt with arithmetically. This is called the “money-measurement concept” and is a fundamental principle of accounting.
This is great, but the problem is not yet solved. An asset may be recorded in dollars and cents (or whatever currency is appropriate for the country in which you live), but at what value? If I were allowed to choose the value I thought was appropriate for my assets, my tendency would be to state their value at the highest amount possible. That way, my financial statement would indicate that my business was strong, healthy, and worth a lot of money. Remember the “accounting equation”:
                                                
                                                        ASSETS – LIABILITIES = EQUITY

Higher assets mean higher equity. Wonderful, but what if I’m wrong? My banker and my investors are trusting that my financial statements are stated accurately. Furthermore, it is not reasonable to expect that every reader of my financial statements can or should have to appraise my assets.
In order to avoid the subjectivity of market value, an objective way of valuing assets had to be established. This was solved by using the “historical cost” concept. This concept states that the numbers reported on accounting financial statements shall be recorded at the amount that was actually paid for an asset, i.e., historical cost. Therefore, accounting does not record what an asset is actually worth, that is, its market value. This works out okay because most businesses are using their assets to conduct operations and are not trying to sell them. When a business offers an asset for sale, or perhaps the entire business, an appraisal to determine fair-market-value of the assets must be performed.
So we (preparers of financial statements) are going to use money as a measurement system and we will record our assets at the amount actually paid for them. This will keep us out of trouble and make it easier to understand what others are doing.

Accrual vs. Cash

For the non-accountant, accrual accounting can seem as mysterious as Egyptian hieroglyphics. When working with basic small business financial statements, the accrual concept is easy to understand. However, in more complex business environments accrual accounting can become as exacting and tedious in its application as deciphering hieroglyphics. Fortunately, we are going to be discussing the
former, not the latter.
Let’s say you are in the business of selling T-shirts. Today you sold four T-shirts for $10 each. Two of the T-shirts sold were paid for with cash,i.e., $20. The other two were sold “on account”. In other words, the customers said they would pay you later. These two transactions have to be recorded differently on your books. Here is the journal entry for the first transaction.

Does this make sense? Check it against the Accounting Model. You increased Cash and you increased Sales, so are the amounts recorded properly in the debit and credit columns?
How about the “pay you later” transaction? We call that a “receivable” because money is owed to the business. Here is how it looks in journal entry form:

Sales are said to be “accrued” when the payment for the goods or services is deferred to a later date. But, you might ask: Why are both the Cash and Accounts Receivable amounts listed in the debit column? It should be obvious that the General Ledger (GL) Sales account belongs in the Revenue section, but what section do the GL accounts, Cash and Accounts Receivable belong? They are Assets. Why? Because both of the items represent an economic resource that your company has possession and control over that will provide a future benefit. What happens when an Asset is increased? The Accounting Model tells us that
an increase of an Asset belongs on the “debit” side of the ledger.