Cost Principle

Definition of Cost Principle

As per the cost principle, all the assets in an organisation’s financial statements should be recorded at their cost, i.e. the total expense incurred on them when they were acquired or purchased. This is also known as the historical cost concept. Change in the asset’s market value or any sort of inflation does not impact its value reflecting on the balance sheet.

Explanation

The historical cost concept, which advocates recording the asset at its original cost, is basic accounting principles as per US GAAP (Generally Accepted Accounting Principles). As per this principle, the value of assets in the financial statements remains the same even if their market value increases or decreases. The assets are recorded at their original cost after accounting for depreciation, if any.

The cost principle is mostly appropriate for short term assets as the business unit does not keep them for too long, and their value doesn’t change that swiftly before they are sold. The principle is not justifiable for financial assets where the value has to be adjusted to the market value at the end of each year. It is also not appropriate for long term assets as the concept does not allow for upward revaluation of these assets, and they will never show actual market value in the long term.

Example of Cost Principle

Let’s say a company purchased machinery for $50,000 3 years ago and a building for $100,000 5 years ago. Now, the market value of machinery is $20,000, but as per books, after applying depreciation, the value is showing as $ 30,000. The difference between the two values is that the organisation follows the cost principle for its assets and has not considered the change in market value.

For building, the value has increased two times, and the current value is $200,000. However, the building is reflecting at $50,000 in the financial statements after accounting for depreciation adjustment. This is because the organization is recording its assets at the original cost following the cost principle.

Implications of the Cost Principle

The most important implication of the cost principle is that it does not allow matching the book value of the assets with their present market value, and thus revaluation adjustment can’t be made for the change in the market value of the assets. Following the cost principle also leads to the non-recognition of self-generated intangible assets like goodwill, brand name, and loyalty. They are built over time and not acquired or built by incurring a cost. Since they do not have initial costs, they cannot be recorded on the company’s balance sheet due to the cost principle.

Exceptions to Cost Principle

There are some assets which are considered as an exception to the cost principle; some of them are as follows:

• The book value of financial investments is required to be adjusted to their market value at the end of each year.
• Liquid assets that can be converted into cash within a period of one year should be recorded at market value.
• Receivables should be recorded at their net realizable value.
• Long term assets having quoted market value should be shown at the current market value in the financial statement.

Advantages of the Cost Principle

Advantages of using the cost principle are as follows:

• It is easy to understand, simple, and straightforward to implement.
• The values recorded can be easily verified from an invoice, a receipt, bank transfer, etc.
• It is a cheaper alternative as the auditor will not have to go in length to verify the recorded cost.

Disadvantages of the Cost Principle

Below are some disadvantages are:

• It does not take into account the fair value of the assets, and thus, it does not show the true picture of assets in the financial statement.
• It does not allow for the scope of showing internally generated intangible assets built over time like brand loyalty, brand name, goodwill, etc.
• At the time of selling, the difference between market value and the asset’s book value could be huge as the cost concept does not consider inflation or any other market value changes.

Conclusion

The cost concept does have its pros and cons. On the one hand, it is reliable, comparable, consistent, employs the principle of objectivity. On the other hand, it does not show the true market value of assets in the financial statement. It is mostly justifiable for short-term assets. It is being followed across the world and is a standard accounting practice.

Recommended Articles

This is a guide to the Cost Principle. Here we also discuss the definition and example of the cost principle along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Costs vs Expenses
2. Horizontal Merger
3. Cost Accounting vs Financial Accounting
4. Replacement Cost