Cost Principle: Explanation and Pros and Cons
Definition
When recording the financial position, the cost principle requires that assets, liabilities, and equity investments to be recorded at the cash amount at the time that item is incurred or acquired regardless if the cost changes over time. Hence, it is also known as a historical principle.
In other words, according to this principle, we do not record transactions based on what we “think” they are worth. We base our values on financial transaction evidence and record the original cost. For instance, Casey’s company purchased an office for $130,000 in 2017 and in 2020 the office space is worth $190,00. Casey needs to record the value of the office on the balance sheet. Casey would record the office value as $130,000 even though it has changed over the years to adhere to the cost principle.
Pros
There are some advantages of utilizing this principle. First of all, it is simple and makes it easy to record the transactions. In addition, it is thought to be more consistent, comparable, reliable because it can be backed up with receipts. Using a valuation basis other than the historical cost could potentially cause issues for the companies. For example, if you utilize the current market value rather than the original cost, each bookkeeper could suggest a different cost amount for every asset the company owns.
Also, the current market value is inappropriate for entities that prepare financial statements more than once a year. This can be seen when computing a net income or preparing a balance sheet on a monthly basis because we will then have to establish a new sales value for that asset at the end of every month, which is highly inconvenient.
Cons
What is wrong with the cost principle companies are required to follow? The first issue is accuracy because the value can fluctuate over time. Accordingly, the data in financial records may no longer be relevant as acquisitions and current market costs may significantly differ.
Moreover, not all assets are recorded using this principle. It is not applicable, for example, to investments. In these cases, at the end of each period, the bookkeeper would need to adjust the amounts of such investments on the books to their fair values.
The business’s true financial position is also negatively affected by the cost principle. If the company wants to sell the assets, the sale price may be only the slightest relationship to those amounts reported on the financial reports.
Since the financial position can be substantially distorted, it is probably the most questionable principle in accounting. To be fair, when applying the cost principle to short-term assets and liabilities, the use of this principle is going to be justifiable because the entity would not have had these items on their books for long enough for the values to alter dramatically.