March 30, 2021

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Cost Principle Definition and Role in Accounting

Cost Principle Definition and Role in Accounting

Definition

The definition of cost principle is a rule according to which business transactions are reflected in the accounting documents in accordance with their value at the time of the initial transaction (the cost paid to purchase the asset), and not according to their fair market value. In other words, the cost principle requires transactions and financial values ​​to be shown according to actual costs or returns, regardless of subsequent changes in the value of the related assets.

Cost Principle Definition and Role in Accounting

Example

The Construction Co. has purchased land for developing houses at the amount of $180,000. Four years later, with the booming real estate market, the market value has increased to $235,000. How should the company’s bookkeeper record this transaction on the Balance sheet? Although the price of the land has significantly increased, the value of an asset would remain unchanged in the accounting records at the cost of $180,000.

Importance

The cost principle is an important aspect of the Generally Accepted Accounting Principles. Yet, many find it difficult to comply with the cost principle, since past costs do not allow properly assessing the current financial position of the company at the moment. It is often argued that recording assets at their current value provides a more realistic view of a company’s financial position. However, valuing assets on the basis of their fair market value would create a number of problems.

Cost Principle Definition and Role in Accounting

Fair value accounting can be difficult for both preparers and users of financial statements. The concept of current value can be interpreted in different ways. For example, if we take a broad definition of this concept, then both the replacement cost and the amount that the asset could be sold for can be taken as the current value.

The current value, thus, can be calculated in two ways, and, accordingly, you can get two completely different values. In other cases, an expert’s opinion is used to value the asset. Accordingly, financial statements may cause distrust on the part of users.

It is believed that recording assets at their original cost provides more reliable information. This reflection of assets in the business’s reports reduces the need for subjective assessment since the amount paid for certain assets is usually documented in an old-fashioned way or accounting software and can be easily retrieved.

To summarize, there are several benefits of the cost principle. Advocates of the historical cost principle believe the system to be more objective, consistent, verifiable, reliable, and comparable. Besides, it is easy to use because you just need to enter the cost in the accounting books. At the same time, this principle is often criticized for its inaccuracy since the value of an asset can change over time. The cost principle may not reflect the business’s true financial position. As you can see, this principle is the most controversial accounting principle you will come across.

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Author: Charles Lutwidge

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