If a company has buildings, equipment and inventory, the cost principle will mean that the amount of depreciation expense and the cost of goods sold expense will be based on the costs when the assets were acquired. If these assets have increased in value, the depreciation and cost of goods sold reported on the income statement will be less than the value of the economic capacity being used up. As a result, the reported net income will be greater than the economic reality.
To illustrate this point let’s assume that the cost of a bank building was $10 million and was fully depreciated during its first 30 years of use. The cost principle requires the depreciation expense on the bank’s income statement for year 31 (and each year thereafter) to be $0 even if the bank building’s market value has doubled. Similarly, a manufacturer using equipment that is fully depreciated will have lower manufacturing overhead and lower cost of goods sold because the current year’s depreciation for the equipment is $0.
Generally, the cost principle requires that only the verifiable, historical costs recorded at the time of transactions will appear as expenses on the income statement. Unfortunately those recorded costs may not measure the economic reality that is occurring in the period of the income statement.
