The cost principle
/What is the Cost Principle?
The cost principle requires you to initially record an asset, liability, or equity investment at its original acquisition cost. The principle is widely used to record transactions, partially because it is easiest to use the original purchase price as objective and verifiable evidence of value. A variation on the concept is to allow the recorded cost of an asset to be lower than its original cost, if the market value of the asset is lower than the original cost. However, this variation does not allow the reverse - to revalue an asset upward. Thus, this lower of cost or market concept is a crushingly conservative view of the cost principle.
Applicability of the Cost Principle
How the cost principle is applied depends on the situation, as noted below. The following three situations describe different applications:
Cost principle for short-term assets and liabilities. Using the cost principle for short-term assets and short-term liabilities is the most justifiable, since an entity will not have possession of them long enough for their values to change markedly prior to their liquidation or settlement.
Cost principle for securities. The cost principle is not applicable to financial investments, where accountants are required to adjust the recorded amounts of these investments to their fair values at the end of each reporting period.
Cost principle for long-term assets and liabilities. The cost principle is less applicable to long-term assets and long-term liabilities. Though depreciation, amortization, and impairment charges are used to bring these items into approximate alignment with their fair values over time, the cost principle leaves little room to revalue these items upward. If a balance sheet is heavily weighted towards long-term assets, as is the case in a capital-intensive industry, there is a greater risk that the balance sheet will not accurately reflect the actual values of the assets recorded on it.
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Exceptions to the Cost Principle
The cost principle has several key exceptions due to evolving accounting standards and the need for more relevant financial information. These exceptions include the following:
Fair value accounting. Certain financial instruments, such as marketable securities and derivatives, are reported at fair value instead of historical cost under U.S. GAAP and IFRS.
Impairment of assets. If an asset’s market value drops below its book value and is not expected to recover, an impairment loss must be recorded, reducing the asset’s value below its original cost.
Inventory valuation. Inventory is sometimes reported at the lower of historical cost or market value/net realizable value, especially when the inventory becomes obsolete or declines in value.
Biological assets. Under IFRS, biological assets like livestock or crops are valued at fair value less costs to sell, not historical cost.
Investment property (IFRS). Investment properties may be measured at fair value with gains and losses recognized in income, rather than using historical cost.
Revaluation of long-lived assets (IFRS). Companies may choose to revalue fixed assets such as property, plant, and equipment to fair value, diverging from the historical cost model.
Intangible assets acquired in a business combination. These are initially recorded at fair value rather than historical cost.
These exceptions exist to enhance the relevance and reliability of financial statements in reflecting an entity’s actual financial position.
The Cost Principle and Asset Revaluation
The cost principle implies that you should not revalue an asset, even if its value has clearly appreciated over time. This is not entirely the case under Generally Accepted Accounting Principles, which allows some adjustments to fair value. The cost principle is even less applicable under International Financial Reporting Standards, which not only permits revaluation to fair value, but also allows you to reverse an impairment charge if an asset subsequently appreciates in value.
Problems with the Cost Principle
The obvious problem with the cost principle is that the historical cost of an asset, liability, or equity investment is simply what it was worth on the acquisition date; it may have changed significantly since that time. In fact, if a company were to sell its assets, the sale price might bear little relationship to the amounts recorded on its balance sheet. Thus, the cost principle yields results that may no longer be relevant, and so of all the accounting principles, it has been the one most seriously in question. This is a particular problem for the users of a company's balance sheet, where many items are recorded under the cost principle; as a result, the information in this report may not accurately reflect the actual financial position of a business.
Terms Similar to the Cost Principle
The cost principle is also known as the historical cost principle.
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