Updated July 14, 2023
Definition of Cost Principle
As per the cost principle, all the assets in an organization’s financial statements should record at their cost, i.e., the total expense incurred when they acquire or purchase. 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 a basic accounting principle 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.
It 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 adjust 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
Suppose 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 organization follows the cost principle for its assets and has not considered the change in market value.
For the building, the value has increased two times, and the current value is $200,000. However, after accounting for depreciation adjustment, the building reflects $50,000 in the financial statements. This is because the organization records 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. Thus, we cannot make a revaluation adjustment for the change in the market value of 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 costs. Since they do not have initial costs, they cannot record on the company’s balance sheet due to the cost principle.
Exceptions to the 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 must adjust to their market value at the end of each year.
- Liquid assets that can convert into cash within a period of one year should record at market value.
- Receivables should record at their net realizable value.
- Long-term assets with quoted market value should be shown at the current market value in the financial statement.
Advantages of the Cost Principle
Some advantages 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, a bank transfer, etc.
- It is a cheaper alternative as the auditor will not have to go to length to verify the recorded cost.
Disadvantages of the Cost Principle
Below are some disadvantages are:
- It does not consider 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.
- When 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, and 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.
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This is a guide to the Cost Principle. Here we also discuss the definition and example of the cost principle and its advantages and disadvantages. You may also have a look at the following articles to learn more –
