Cost principle – What is the cost principle?
The cost principle is an accounting principle that requires assets, liabilities, and equity investments to be recorded on financial records at their original cost.
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According to the cost principle, transactions should be listed on financial records at historical cost – i.e. the original cash value at the time the asset was purchased – rather than the current market value.
The cost principle is also known as the historical cost principle and the historical cost concept.
The cost principle, appreciation, and depreciation
It is common for an asset’s price to diverge from its historical cost; however, because the cost principle specifies that financial records should not be adjusted, you should always follow specific processes to account for any changes.
Appreciation is an increase in the value of an asset. Appreciation is treated as a gain and the difference in value should be recorded as ‘revaluation surplus’.
For example, a company purchases an office for £100,000 in 2012. In 2018, the property is valued at £120,000. Rather than changing entries in accounting records to reflect the new market value, the difference in price should be credited to an equity account called ‘revaluation surplus’.
Depreciation is the decrease in the value of an asset. There are several different ways to account for depreciation but, in general, depreciation is treated as a loss and is expensed throughout the asset’s useful life.
For example, a laptop is purchased for £1,000. It expected to have a useful life of 5 years and a residual value of £200. The balance sheet continues to report the value of the laptop as £1,000, but £160 is expensed to a depreciation account each year of its useful life.
Advantages and disadvantages of the cost principle
The cost principle is considered one of the fundamental guidelines for bookkeeping and accounting; however, it is fairly controversial. As such, accounting standards are starting to move away from the cost principle. According to critics of the cost principle, it's main disadvantage is lack of accuracy. Because assets appreciate and depreciate, financial records which follow the cost principle are unlikely to accurately reflect a business’s actual financial position.
The cost principle also means that some valuable, non-tangible assets are not reported as assets on the balance sheet. For example, goodwill, brand identity, and intellectual property can add a lot of value to a business but, because they are built up over time, they do not have an initial purchase price to record on financial statements.
On the other hand, advantages of the cost principle include:
- Ease: It is much quicker and more straight-forward to record assets at their original value than to continually update financial reports to reflect current market value.
- Objectivity: The cost principle means that recorded values are objective and verifiable as invoices, sales receipts, and bank transactions easily confirm the original purchase price.
- Cost: Because it is quicker and easier to verify the value of assets, accountants and auditors need to spend less time verifying financial records, making it cheaper for the companies who employ them.
Exceptions to the cost principle
According to some accounting standards, particular assets, liabilities, and equity investments are exempt from the cost principle. For example:
- Accounts receivable should be shown at net realisable value.
- Highly liquid assets (assets which are expected to be turned into cash in the very near future) should be recorded at their current market value.
- Assets that have a quoted, market-ready value should be recorded at their current market value.
- Financial investments should be recorded at fair value at the end of each accounting period.