Historical Cost

The historical cost accounting is an accounting technique that values an asset for balance sheet purposes at the price paid for the asset at the time of its acquisition. 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 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 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The most prominent disadvantage of this method is that book values may be based on badly out of date costs.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. Historical-cost financial statements do not provide information that is relevant to investors.

Fair value is defined as the amount at which the asset could be bought or sold in a current transaction between willing parties. Fair value is a reliable estimate if the parties involved in the transaction are “knowledgeable” where they are aware of the relevant risks and rewards, utility of the asset, supply and demand of asset, market conditions, and other factors. The transaction should be an arm’s length transaction. Arm’s length transaction means that the parties to the transaction are acting in their own interest. A