Cost principle
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The cost principle is a part of Accounting Principles, which are general ways used in identification and calculation in accounting events. There are necessities to stabilize accounting in countries (S. Nyquist 2000, p. 181). Cost principle was pioneered in 1991 by the Global Environment Facility (GEF) (G. Labbate 2008).
There are a few different types of Accounting Principles (S. Nyquist 2000, p. 181):
- the cost principle,
- realization principle,
- matching principle,
- objectivity principle,
- materiality principle,
- full disclosure principle,
- consistency principle,
- conservatism principle.
What is cost principle
Cost principle, which is often called exchanged-price principle, request an accountant to register transfers of resources at prices that were agreed by the sides taking part in exchange in the moment of the transaction (R. Hermason, J. Edwards, M. Maher 2010, p. 260).
Three aspects that are set by cost principles are (R. Hermason, J. Edwards, M. Maher 2010, p. 260):
- transaction data - what should go into the accounting system,
- time of exchange - when a transaction takes place,
- exchange prices - amounts at which assets, liabilities, stockholders' equity, expenses and revenues were recorded.
R. Hermason, J. Edwards, M. Maher (R. Hermason, J. Edwards, M. Maher 2010, p. 260) state that accountants prefers the term exchange-price principle than cost principle. That's because they feel like using the term “cost” is inappropriate to name things like liabilities, stockholders' equity, and such assets as cash and accounts receivable.
Historical Cost Principle
Based on the fact that cost principle dictates purchased or self-constructed assets to be initially documented as a historical cost, it is often referred to as the historical cost principle. Historical cost can be described as the paid amount, or the fair market value of the liability incurred or different resources surrendered, to obtain an asset and establish it in a condition and position for its intended use (R. Hermason, J. Edwards, M. Maher 2010, p. 260).
In recent years Financial Accounting Standards Board (FASB) are usually replacing the historical cost principle with fair value principle, which means documenting the value of an asset or liability at its current market (fair) value rather than its book (historical) value (D. V. Kousenidis, A. C. Ladas, C. I. Negakis 2010, p. 146; R. Hermason, J. Edwards, M. Maher 2010, p. 260).
Examples of Cost principle
- Initial Recognition: The cost principle states that all assets acquired by a business should be recorded at the cost of acquisition. This includes the original cost of the asset, as well as any costs associated with the purchase. For example, when a company buys a new piece of machinery, it is recorded at the cost of the machinery and any associated costs such as shipping, installation, and taxes.
- Subsequent Measurement: The cost principle also states that assets should be measured at their original cost. This means that any changes in the market value of the asset should not be reflected in the financial statements. For example, if a company purchased a piece of machinery for $10,000 and its market value later increases to $15,000, the company would still record the asset on its balance sheet at the original cost of $10,000.
- Impairment Losses: The cost principle also dictates that when an asset becomes impaired or damaged, its value should be adjusted to the lower of its cost or its current market value. This is because the impairment will reduce the asset’s future service potential and its value should be adjusted accordingly. For example, if a company purchased a piece of machinery for $10,000 and it later becomes damaged and its market value is now $7,000, the company should record the asset on its balance sheet at $7,000.
Advantages of Cost principle
The following are the advantages of the cost principle:
- It provides a useful framework for organizations to accurately measure and record costs associated with their operations. It ensures that organizations can accurately measure and record their costs, enabling them to better understand how much money they are spending on certain activities.
- It helps to ensure that organizations are aware of the cost of goods and services, and that they are not overspending on certain activities. This helps to keep costs down and ensure that the organization is operating in a cost-effective manner.
- It allows organizations to compare the costs of different activities and make decisions that are in the best interests of the organization. This helps to ensure that the organization is making the most efficient use of its resources.
- It ensures that organizations are able to properly track changes in costs over time, which can help organizations make informed decisions about future investments. This helps to ensure that organizations are making the best use of their resources.
Limitations of Cost principle
The Cost Principle has several limitations:
- It does not take into account the time value of money. This means that it does not take into consideration the future changes in cost due to inflation or deflation.
- It does not consider the opportunity cost of assets. This means that it does not take into consideration the economic benefit that could be obtained by investing the money in other assets.
- It does not take into consideration the externalities associated with the assets. This means that it does not take into consideration the environmental, social or economic impact that the asset may have on the surrounding area.
- It does not consider the current market value of the asset when determining the cost of the asset. This means that it does not consider the current market price of the asset when determining the cost of the asset.
- It does not consider the quality of the asset when determining the cost of the asset. This means that it does not take into consideration the quality and performance of the asset when determining the cost of the asset.
The cost principle is an important part of the Accounting Principles, which are general ways used in the identification and calculation of accounting events. There are a variety of approaches related to the cost principle, such as:
- The Matching Principle – this principle states that a company should report expenses in the same period as the related revenues. This ensures that the financial statements accurately reflect the company’s performance and that expenses are not overstated or understated.
- The Accrual Principle – this principle states that revenues and expenses should be reported in the period in which they are earned or incurred, rather than when the cash is received or paid. This allows for a better assessment of the company’s financial performance and results.
- The Conservatism Principle – this principle states that companies should err on the side of caution when reporting financial information. The purpose of this is to ensure that the financial statements are not overstated or optimistic, and that investors receive accurate information.
In summary, the cost principle is an important part of Accounting Principles, and there are a variety of approaches related to it, such as the Matching Principle, the Accrual Principle, and the Conservatism Principle. These approaches are used to ensure the accuracy and reliability of financial statements.
References
- Ellul Andrew and others (2015), Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading, The Journal of The American Finance Association, vol. 70, no. 6
- Hermason R., Edwards J., Maher M. (2010), Accounting Principles: A Business Perspective, Financial Accounting. Chapters 1 - 8, Open College Textbook
- Kousenidis D. V., Ladas A. C., Negakis C. I. (2010), Value Relevance of Accounting Information in the Pre- and Post-IFRS Accounting Periods, European Research Studies, vol. 13, no. 1
- Labbate G. (2008). The incremental cost principle and the conservation of globally important habitats: A critical examination, Ecological Economics, vol. 65, no. 2
- Nissim D. Penman S. (2008) Principles for thr Applicattion of Fair Value Accounting, Columbia Business School, White Paper Number Two
- Nyquist S. (2000). Accounting theory and financial environmental reports, Corporate Social Responsibility and Environmental Management, vol. 7, no. 4
Author: Olga Marmuszewska
