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Friday, 21 March 2008

Historical Cost

In historical cost accounting, historical cost is the original monetary value of an economic item.

When an historical cost item, for example money or retained income, is never updated its real value is destroyed at the rate of inflation in low inflationary economies. Money cannot be updated. Retained income is currently not updated in low inflationary economies as a result of the application of the stable measuring unit assumption. Retained income is:

The accumulated net income retained for reinvestment in a business, rather than being paid out in dividends to stockholders.

One of the basic principles in accounting is:

“The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.” .

The combination of the historical cost accounting model and low inflation is thus indirectly responsible for the destruction of the real value of retained income equal to the annual average value of retained income times the average annual rate of inflation.

From Wikipedia: Historical Cost: http://en.wikipedia.org/wiki/Historical_cost