historic cost

6.5 Limitations of Accounting Statements – Historic Cost

1 Fundamentals of Accounting

• Purpose of accounting: record financial transactions, provide information for decision‑making, and demonstrate accountability.
• Accounting equation: Assets = Liabilities + Owner’s Equity. Every transaction must keep this equation in balance.
• Book‑keeping vs. accounting:
  • Book‑keeping – systematic recording of all financial transactions (source documents → books of prime entry → ledgers).
  • Accounting – interpretation, classification, summarising and reporting of the recorded data in the financial statements.

2 Sources & Recording of Data

2.1 Key Business Documents

• Invoice (sales & purchase)
• Receipt / Payment voucher
• Bank statement
• Credit note / Debit note
• Petty‑cash slip

2.2 Books of Prime Entry (Books of First Entry)

Book	Purpose	Typical Entries
Cash Book	Record all cash receipts and payments.	Cash sales, cash purchases, bank receipts, bank payments.
Sales Journal (Sales Day Book)	Record credit sales of goods.	Sale of inventory on credit, trade discounts.
Purchases Journal (Purchases Day Book)	Record credit purchases of goods.	Purchase of inventory on credit, cash discounts received.
General Journal (Journal proper)	Record all other transactions (e.g., depreciation, accruals, errors).	Depreciation, wages accrued, correction of errors.

2.3 Journal → Ledger Flow

1. Identify the transaction and collect the supporting document(s).
2. Enter the transaction in the appropriate book of prime entry.
3. Post each entry to the relevant ledger accounts (sales, purchases, nominal, personal, real).
4. Balance each ledger account and prepare a trial balance.

2.4 Division of the Ledger

Ledger Type	Typical Accounts
Real (Asset) Ledger	Cash, Bank, Machinery, Stock, Pre‑paid expenses.
Personal Ledger	Capital, Loan, Trade creditors, Trade debtors.
Nominal (Expense & Revenue) Ledger	Sales, Purchases, Wages, Depreciation, Rent.

2.5 Trade vs. Cash Discounts

• Trade discount – reduction in the list price given at the point of sale; recorded only in the sales/purchases journals (no entry in the ledger).
• Cash discount – incentive for early payment; recorded in the ledger.
  Example (Cash discount received):

  Purchase of goods £1,000
  Cash discount 2 % = £20
  Journal entry:
     Purchases          £1,000
        Creditors                £1,000
     (to record purchase)
  
     Creditors          £20
        Cash discount received    £20
     (to record discount received)
          

2.6 Imprest Petty‑Cash System

• Fixed amount of cash kept on hand for small, irregular expenses.
• When the cash is exhausted, a petty‑cash voucher is prepared and the imprest amount is restored by a bank payment.
• At month‑end the balance is reconciled and any shortage or surplus is recorded as an expense or income.

3 Verification of Accounting Records

3.1 Trial Balance – Purpose & Common Errors

The trial balance checks that total debits equal total credits after posting.

Error Type	Description	Effect on Trial Balance
Omission	Transaction omitted entirely.	No effect – totals still balance.
Commission	Same amount entered on the same side of two accounts.	No effect.
Compensating	Two errors of opposite effect cancel each other.	No effect.
Transposition	Digits reversed (e.g., £ 540 recorded as £ 450).	Totals differ by a multiple of 9.
Single‑side error	Amount entered on the wrong side of an account.	Totals differ.
Double‑entry error	Both sides wrong but amounts are equal.	No effect.

3.2 Correcting Errors

• Identify the error by reviewing the trial balance and the original entries.
• Prepare a correcting journal entry (or a series of entries) to reverse the wrong entry and record the correct one.
• If the error cannot be traced immediately, use a suspense account to balance the trial balance and investigate later.

3.3 Suspense Account

Used when the trial balance does not balance and the exact error is unknown.

Debit side total  £ 25,800
Credit side total £ 26,200
Difference        £   400 (credit)

Journal entry:
   Suspense Account   £400
      (to balance the trial balance)

When the error is found, the suspense balance is transferred to the correct account.

3.4 Control Accounts

• Summarise the totals of subsidiary ledgers (e.g., Purchases Ledger Control, Sales Ledger Control).
• Assist in detecting errors in the detailed ledgers.
• Example – Purchases Ledger Control:

  Total purchases recorded in Purchases Journal    £ 45,000
  Total of individual creditors’ balances          £ 44,200
  Difference (unreconciled)                        £   800 (debit)
  
  Journal entry to correct:
     Purchases Ledger Control   £800
        Creditors                         £800
          (to bring control account in line)
          

3.5 Bank Reconciliation Statement (Simple Format)

Cash book balance                 £5,200
Add: Deposits not yet credited    +£300
Less: Cheques not yet presented   -£150
-----------------------------------------
Adjusted cash book balance        £5,350

Bank statement balance           £5,350

4 Accounting Procedures

4.1 Capital vs. Revenue Expenditure

• Capital expenditure creates or enhances an asset (e.g., purchase of machinery). Recorded as an asset and depreciated over its useful life.
• Revenue expenditure relates to the day‑to‑day running of the business (e.g., repairs, wages). Charged to the profit‑and‑loss account in the period incurred.

4.2 Depreciation Methods

Method	Formula / Calculation	Numerical Example (Machinery £50,000; useful life 5 years; residual £0)
Straight‑Line (SL)	Annual charge = (Cost – Residual) ÷ Useful life	£50,000 ÷ 5 = £10,000 each year
Reducing‑Balance (RB) – 20 % per year	Charge = Opening NBV × Rate	Year 1: £50,000 × 20 % = £10,000 → NBV £40,000 Year 2: £40,000 × 20 % = £8,000 → NBV £32,000 …
Revaluation (fair‑value) method	Asset restated to current market value; depreciation thereafter on the revalued amount.	Market value 31 Dec 2024 = £80,000. Accumulated SL depreciation = £40,000. New NBV = £80,000 – £40,000 = £40,000. Remaining life 2 years → depreciation £20,000 per year.

4.3 Accruals & Pre‑payments

• Accrued expenses – costs incurred but not yet paid (e.g., wages earned by staff at month‑end). Recorded as a liability.
• Pre‑paid expenses – payments made in advance of the benefit (e.g., insurance). Recorded as an asset and expensed over the period of use.

4.4 Provisions

Liabilities of uncertain timing or amount (e.g., warranty provision). Recognised when a present obligation exists and the amount can be estimated reliably.

4.5 Inventory Valuation

Inventories are measured at the lower of cost and Net Realisable Value (NRV). Cost is normally the historic purchase cost; NRV is the estimated selling price less costs of completion and disposal.

5 Preparation of Financial Statements (Mini‑case – Sole Trader “ABC Crafts”)

5.1 Assumptions

• All figures are at historic cost unless otherwise stated.
• Depreciation on machinery is straight‑line (£10,000 per year).
• Insurance prepaid covers the next financial year.

5.2 Data Summary

Item	Amount (£)
Cash at 31 Dec 2024	5,200
Machinery (cost £50,000; accumulated SL depreciation £30,000)	20,000
Stock (cost £12,000; NRV £11,000)	11,000
Bank loan (long‑term)	30,000 (liability)
Capital (owner’s equity)	18,200
Sales revenue (year)	45,000
Purchases (incl. freight)	20,000
Wages accrued (not yet paid)	2,500 (liability)
Insurance prepaid (covering next year)	1,200 (asset)

5.3 Statement of Financial Position (Balance Sheet) – 31 Dec 2024

Assets	£	Liabilities & Equity	£
Cash	5,200	Bank loan	30,000
Machinery (cost less depreciation)	20,000	Accrued wages	2,500
Stock (lower of cost/NRV)	11,000	Capital	18,200
Pre‑paid insurance	1,200
Total assets	37,400	Total liabilities & equity	37,400

5.4 Income Statement (Profit & Loss Account) – Year ended 31 Dec 2024

Revenue & Gains	£	Expenses & Losses	£
Sales revenue	45,000	Purchases	20,000
		Depreciation (SL)	10,000
		Accrued wages (expense)	2,500
		Insurance expense (current year portion)	800
		Total expenses	33,300
Gross profit	45,000
Net profit	11,700

Note: The machinery is shown at historic cost (£20,000 net) even though its market value in 2024 is £80,000 – an illustration of the historic‑cost limitation.

6 Analysis & Interpretation

6.1 Ratio Spotlight (using the mini‑case)

• Gross Margin = (Sales – Cost of Goods Sold) ÷ Sales = (45,000 – 20,000) ÷ 45,000 = 55.6 %.
• Current Ratio = Current assets ÷ Current liabilities = (Cash 5,200 + Stock 11,000 + Pre‑paid 1,200) ÷ (Accrued wages 2,500) = 17,400 ÷ 2,500 = 6.96.

Because the machinery is recorded at historic cost, the current ratio is unaffected, but total assets are understated. If the machine were revalued to £80,000, total assets would rise to £107,400 and the current ratio would fall to 1.74, presenting a very different liquidity picture.

7 Accounting Principles & Policies (Cambridge IGCSE)

8 Historic Cost – Key Limitations

• Irrelevance over time – The recorded amount may be far from the asset’s current economic value.
• Inflation distortion – In high‑inflation periods, historic cost understates purchasing power.
• Non‑comparability – Assets bought at different dates carry different original costs, making side‑by‑side comparison misleading.
• Under‑statement of profit – Gains are recognised only on disposal; unrealised increases are ignored.
• Misleading financial position – Balance sheets can show a lower net asset value than would be realised on sale.

Illustrative Example (Machinery)

Purchase price (2015) = £50,000.
Straight‑line depreciation (5 years) = £10,000 per year.
Accumulated depreciation by 31 Dec 2024 = £30,000.
Historic‑cost carrying amount = £50,000 – £30,000 = £20,000.
Market value 2024 = £80,000.
The balance sheet records £20,000, understating assets by £60,000.

9 Comparison of Measurement Bases

Aspect	Historic Cost	Current (Fair) Value
Objectivity	High – based on actual transaction price.	Lower – relies on estimates, market data and professional judgement.
Relevance	Can become low as time passes.	High – reflects present economic conditions.
Impact of inflation	Significant – assets appear undervalued.	Mitigated – values are regularly updated.
Complexity	Simple – easy to apply.	Complex – requires periodic re‑valuation.
Effect on profit & loss	Gains/losses recognised only on disposal.	Unrealised gains/losses may be recognised each period.

10 How Examiners Test Knowledge of Historic Cost

1. Explain why historic cost provides reliability but can reduce relevance.
2. Identify and discuss at least three limitations of the historic‑cost convention.
3. Calculate the carrying amount of an asset using historic cost and compare it with a given market value.
4. Analyse the effect of re‑valuing an asset on:
   • Balance‑sheet totals,
   • Liquidity ratios (e.g., current ratio), and
   • Profit‑or‑loss (recognition of unrealised gains/losses).
5. Present a short answer or structured response on the differences between historic cost and fair value, including the impact on objectivity, relevance and complexity.