Accounting Concepts & Historical Cost
The use of historical cost to record long-lived assets is primarily justified by the going concern convention. This convention assumes that a business entity will continue to operate indefinitely into the foreseeable future.
Reasoning for Going Concern Convention
- Because the business is expected to continue operating, its assets are intended to be used in the generation of revenue, not sold immediately.
- The historical cost represents the actual amount paid to acquire the asset, which is considered a reliable and verifiable measure at the time of purchase.
- Under the going concern assumption, the asset's value in use is more relevant than its immediate market or liquidation value. Historical cost serves as the initial, objective basis for recording the asset.
Why Other Options Are Less Relevant
- The entity concept: This separates the business's finances from the owner's but doesn't directly dictate the valuation method based on future operations.
- Materiality convention: This relates to the significance of an item; items below a certain threshold might be treated differently, but it doesn't fundamentally justify using historical cost for all major assets.
- The periodicity convention: This involves dividing the business's life into specific time periods (like months or years) for reporting. While important for depreciation and financial statements, it doesn't directly underpin the initial recording of assets at historical cost.
Therefore, the going concern convention provides the foundation for using the initial, verifiable historical cost for recording long-lived assets, assuming they will be used over their useful life within an ongoing business.
Important Questions from Basic accounting principles
The generally acceptable accounting principles (GAAP) fulfill the conditions of
(i) Relevance
(ii) Objectivity
(iii) Feasibility
A firm purchases a piece of land after making full payment to the seller. However, the legal formalities are yet to be completed. According to which principle does the firm record the transaction in its books of accounts though the legal formalities are NOT completed?
Which of the given options best describes the truthfulness of the following statements?
Statement-1: Generally Accepted Accounting Principles (GAAP) is to be followed by companies so that investors have an optimum level of consistency in the financial statements they use when analyzing companies for investment purposes.
Statement-2: Generally Accepted Accounting Principles (GAAP) cover aspects like revenue recognition, balance sheet item classification and outstanding share measurements.
________ convention underlines the prudence of understating rather than over-stating the net income of an entity for a period and the net assets as on a particular date.
______ convention proposes that while accounting for various transactions, only those which may have significant effect on profitability or financial status of the business should have special consideration for reporting.
