The cost principle is an accounting concept that requires companies to record costs at historical value.
The cost principle is an accounting concept that requires companies to record costs at historical value. This avoids the use of fair or market values, which can change in a short period of time and create confusion in the financial statements. Applications of the cost principle include accuracy, reliability, and consistency. The bottom line usually leads to a conservative approach to reporting financial numbers. Internal and external audiences rely on this information to make decisions and assess the financial viability of a business.
Accuracy is often one of the most important applications of the cost principle. Companies must record transactions at the actual price paid for the items in an arm’s length transaction. In most cases, all activities involving the use of inventory, accounts receivable, or accounts payable require the application of this principle. Failure to do so could result in inaccurate numbers and accounting activities completed inappropriately for the company’s financial statements. The use of historical cost is not without controversy, as companies may underestimate the value of their products.
Reliability is also important when a company records costs. The application of the cost principle here indicates that a company has accurate records to support the entries posted in its ledger. One problem here, however, is that a company generally cannot replace the assets listed on its financial statements at the same cost. Inflation tends to increase the cost of goods in a market. However, stakeholders can rely on this application because the company will likely have to spend at least that much to replace the goods if necessary.
Consistency is also a vital application of the cost principle. Businesses must handle the same or similar transactions in the same way whenever they occur. For example, if a salon records a new purchase of hair dryers as an asset, the same process must occur when purchasing replacement hair dryers. Failure to do so can misrepresent a company’s financial information and misrepresent financial statements. The consistency principle applies to all transactions.
The end result of the cost principle is a conservative approach to the accounting process. The use of historical values can indicate that a company’s items are less than the current costs of replacement goods, but it will never show costs greater than the historical cost. Therefore, the company presents a conservative estimate for its total business. In some cases, however, a company may need to use the fair value principle for some financial statement items.