Resources | Subject Notes | Accounting
Historic cost is a fundamental principle in accounting, meaning assets are recorded at their original purchase price. While it offers objectivity and reliability, it also has several limitations. This section will detail these limitations.
One of the most significant limitations of historic cost is its failure to reflect changes in the purchasing power of money due to inflation.
Consider a piece of equipment purchased for $1,000 in 1990. Under historic cost, it will be recorded at $1,000. However, due to inflation, $1,000 in 2023 has significantly less purchasing power than it did in 1990. This means the asset's value doesn't accurately reflect its current economic worth.
| Year | Purchase Price | Inflation Factor (Example) | Real Value (Approximate) |
|---|---|---|---|
| 1990 | $1,000 | 1.0 | $1,000 |
| 2023 | $1,000 | 1.0 | $1,000 |
Historic cost may not be relevant to current business decisions. The current market value of an asset might be much higher or lower than its original cost.
For example, a building purchased for $50,000 may now be worth $500,000. Reporting it at $50,000 provides a misleading picture of the company's financial position and doesn't reflect the true value of its assets.
In industries with rapid technological advancements, historic cost can be misleading.
A machine purchased many years ago might be obsolete and no longer efficient, even if its historic cost is relatively low. The historic cost doesn't account for the replacement cost of a more modern, efficient machine.
Because historic cost doesn't adjust for inflation or changes in market value, it can make it difficult to compare the financial performance of companies over different periods or across different industries.
A company with older assets might have a lower reported profit than a company with newer, more efficient assets, even if the older company is more profitable in reality.
Historic cost can underestimate the true value of assets, particularly those that have appreciated in value over time. This can lead to an inaccurate representation of a company's financial strength.
In conclusion, while historic cost provides a degree of objectivity, its limitations related to inflation, relevance, technological changes, comparability, and potential understatement of assets mean that it doesn't always provide a complete or accurate picture of a company's financial position and performance. Modern accounting practices often incorporate fair value accounting to address some of these limitations.