The cost principle is an accounting principle that states that all assets, liabilities, and equity investments should be recorded at their original cost on financial records. This principle is also referred to as the historical cost concept. The historical cost concept requires that all transactions be recorded on financial records at historical cost (actual cash value paid when the asset was purchased) rather than current market value.
How is the historical cost concept used?
The historical cost concept ensures that the value of a company’s assets is determined by their actual cost rather than by the ongoing fluctuations in the market. The balance sheet of a business, which includes the valuations of all of its assets and the debts it owes to suppliers, is where the principle is mostly used (business loans used to acquire assets inclusive).
Exceptions to cost principle
The historical cost concept is one of the most standard approaches to tracking the values of multiple significant assets. However, some notable cases exist where historical cost accounting cannot be used. They include:
- Account receivable
Companies should not record customers’ unpaid debt at the total amount owed. Companies should instead use the amount they anticipate receiving once the account is paid (the net realizable balance).
2. Highly liquid assets
The historical cost concept may be too conservative and result in an inaccurate balance sheet if a company possesses assets for which there is a ready market (i.e. the company can quickly sell the asset and turn it into cash). This is particularly true for assets that, despite being liquid, can be kept on a business’s books for a very long time. For instance, the value of shares in publicly traded corporations is determined by their fair market value (plus a possible discount if the company needs to sell at a slight loss).
3. Financial investments
The cost principle cannot be used to record financial investment. Financial investments should be recorded at their current market value at the end of each accounting period. Assets with a quoted, market-ready value should also be recorded at their current market value.
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Advantages and disadvantages of cost principle
Historical cost principle helps businesses to detail the actual cost of expenditures and is easy to maintain from period to period. However, this method does not always accurately reflect the current value of assets and can result in the undervaluation of your business. Let’s discuss the pros and cons of the historical cost concept to understand how items are reflected on the balance sheet and when to use cost accounting for your business.
Advantages:
- It does not require periodic update
Cost accounting eliminates the need to update the values of significant assets on your balance sheet. Even if they(asset value) change over time, you only need to update the values of depreciating assets. While looking for funding or thinking about a merger or acquisition, cost accounting can help you avoid overestimating the value of your assets.
2. It is easy to use and straight forward
Cost accounting is straightforward. The asset’s original cost is the only thing necessary to perform cost accounting. Any capitalised assets can also be depreciated over time. The IRS provides depreciation schedules for taxpayer use, and a certified accountant can also put them into practice. Every asset depreciation produces tax benefits for the business because it can be deducted from the business revenue.
3. It provides accurate cost information for budgeting
Businesses can evaluate how the cost to acquire assets changes over time and make budget decisions based on past purchases and long-term price patterns. This is done by valuing assets at a price paid when the business obtains them. Also, they have access to information about how the values of their assets have changed over time, which helps to decide whether to buy new or used equipment depending on how the value of that equipment is projected to fluctuate.
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Disadvantages:
- It does not account for economic fluctuations.
The fact that cost accounting ignores long-term pricing trends for many significant assets, including real estate, is a flaw. The prices of many assets change over time in predictable ways due to inflation and other reasons. Cost accounting disregards these tendencies and values assets according to strict principles. This approach provides your company with short-term tax advantages. However, it may also result in severe long-term misalignments between your company’s balance sheet and market values.
2. It does not accurately reflect the present worth of an asset.
Computers are company equipment whose price can never appreciate. However, the contrary is true for many capitalised assets, such as real estate or large equipment. A good example is real estate. Due to the constant fluctuation in value, businesses that bought real estate even five years ago would almost surely be able to sell it for greater money today.
But, according to cost accounting, they must continue to value that asset at the amount they originally paid for it, less depreciation. When your company sells an asset, it will be sold at its current market value rather than the price paid for it. This difference is considered a capital gain and is taxable at standard corporate income tax rates.
3. It increases tax liability
Large depreciating assets are particularly affected by this tax. This can lead to depreciation recapture, resulting in a sizable, unforeseen tax liability. Depreciation recapture is the capital gain that results when an asset that has been depreciated for more than its book value is sold.
The bottom line
Cost principle helps to maintain consistency in your balance sheet over time. It avoids having to revise your financial statements to reflect current market values. Using the cost accounting principle, you can keep the asset prices in your company stable and conservative. The actual purchase price of an asset does not change over time, in contrast to fair market value. This makes it less arbitrary and less sensitive to market conditions.
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