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Overview of Cost Principle
Definition of
Cost Principle
What is the Cost Principle? The Cost Principle, also commonly referred to as the Historical Cost Principle, is a fundamental accounting principle stating that assets should be recorded on the Balance Sheet at their original purchase price or acquisition cost. This cost includes all expenditures necessary to acquire the asset and make it ready for its intended use. According to this principle, the asset's value remains at its historical cost in the accounting records throughout its useful life, even if its market value fluctuates significantly. Adjustments to this book value are typically made only through systematic allocation processes like depreciation (for tangible assets) or amortization (for intangible assets), which are based on the original cost. The Cost Principle is a cornerstone of GAAP (Generally Accepted Accounting Principles) due to its emphasis on objectivity and verifiability.
Activities Related to
Cost Principle
Here is a list of Cost Principle related activities:Â
Recording the purchase of assets (like equipment, buildings, land) at their acquisition price, Maintaining fixed asset registers with historical cost data, Calculating depreciation or amortization based on the original cost minus salvage value, Resisting revaluation of assets based solely on market fluctuations (under traditional GAAP), Verifying asset costs through purchase invoices and related documentation, Applying GAAP standards during financial statement preparation.
These activities ensure assets are consistently valued based on their verifiable acquisition cost.
The Importance of
Cost Principle
The Cost Principle is important because it promotes objectivity and reliability in financial reporting. Historical cost is a factual, verifiable amount supported by transaction documentation, unlike market values which can be subjective, difficult to determine consistently, and volatile. This objectivity enhances the comparability and reliability of financial statements over time and between companies. It also simplifies the bookkeeping process by providing a stable, unchanging basis for asset records and subsequent expense allocations (depreciation/amortization). While critics argue it may not reflect an asset's true current economic value, its emphasis on verifiability remains a key reason for its widespread use under GAAP.
Key Aspects of
Cost Principle
Historical Cost Basis
Assets are recorded at the price paid upon acquisition, including any costs to make the asset ready for use.
Objectivity and Verifiability
Relies on actual transaction data, making the initial valuation objective and easy to verify through invoices or contracts.
Stability (Ignoring Market Fluctuations)
Asset values on the books generally do not change simply because market prices go up or down (exceptions exist, e.g., impairment or specific fair value rules).
Concepts Related to
Cost Principle
The Cost Principle is a foundational concept within GAAP that dictates how Assets are initially valued on the Balance Sheet. It uses the original cost or historical cost. This principle provides the basis for calculating subsequent Depreciation and Amortization expenses. It aligns with the accounting principle of objectivity. It contrasts with other valuation methods like fair value accounting, which uses current market values for certain types of assets.
Cost Principle
in Action:
The Adventures of Coco and Cami
Follow the entrepreneurial journeys of Coco, who's opening a sandwich shop, and Cami, starting a coffee shop, as they find themselves faced with the new challenges of bookkeeping to track their businesses.
Watch as Professor A breaks down the fundamental concepts of bookkeeping for Coco and Cami, explaining why it's the essential foundation for understanding a business's financial health.