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What the Cost Principle is and Why You Need to Know It

Posted by Nikki Layton on November 16, 2015 at 6:06 AM

 

Even if you’re a novice in accounting, you probably already know that assets are a crucial part of the accounting process. In fact, they’re an integral part of the accounting equation itself. But how you record your company’s assets also comes into play in one of the foundational accounting principles: the cost principle.

cost-principle


What is the Cost Principle?

One of the underlying accounting principles (along with the conservatism principle and the consistency principle), the cost principle states that your assets will be recorded on the books at whatever their cash value was at the time they were acquired. This means that the asset amounts recorded on your financial statements will be their “actual value," not their current market value.

Why use the original acquisition cost of assets? Generally speaking, this is a way to ensure that an objective and verifiable cost is recorded on the books. However, if the market value of an asset happens to be lower than the original purchase price, then the asset may be recorded at that lower amount (which is in line with the conservatism principle).

The Cost Principle and Depreciation

Although following the cost principle means recording the original acquisition cost of an asset, you will still need to factor in depreciation for certain assets. In a nutshell, depreciation is when the value of long-term assets decreases over time.

Let’s look at an example. Say you acquired a piece of equipment at a cash value of $20,000.00 and the equipment has a useful life of five years. Following the straight-line depreciation method, a depreciation expense of $4,000.00 will be recorded each year. How does this reflect on your balance sheet? The historical cost ($20,000.00) minus the accumulated depreciation will be shown.

Some Issues with the Cost Principle

Although this is a basic principle of accounting, there are a few problems that come up when applying the cost principle. For instance, if your company has any valuable logos or brand names in its possession, these would not be reported as assets on the balance sheet. This would potentially mean that one of your company’s most valuable assets is not being recorded as an asset on the books, which would not really reflect the reality of your financial situation.

Confusion can arise when selling off company assets as well when you’re following the cost principle. If the market value of the asset has changed significantly in the time between its acquisition and its sale, then the sale price will not relate closely to the amount recorded on your balance sheet. This would obviously require some explanation in your financial statements. A change in the value of assets over time is generally a problem for readers of your financial statements when you’re adhering to the cost principle, because it can make it more difficult to determine your company’s exact financial position.

Short-Term vs Long-Term Assets

The issues mentioned above are more prevalent when it comes to dealing with your company’s long-term assets, whose value can fluctuate over time. However, these issues aren’t such a problem with your short-term assets, making the cost principle more suitable for these types of assets. This is because short-term assets are generally not in your company’s possession long enough for their value to change very much. Recording them at their acquisition cost is more likely to be accurate.

As always, if you’re unsure about how to apply the cost principle (or any other accounting principle that we’ve delved into on this blog), it’s a good idea to consult an accounting professional. Remember that this is meant as a general guide, not legal advice!

Topics: Accounting Basics