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 using market or fair values, which can change over a short period of time and create confusion in the financial statements. Applications of the cost principle include accuracy, reliability, and consistency. The end result typically leads to a conservative approach to reporting financial numbers. Internal and external audiences rely on this information to make decisions and assess a company’s financial viability.
Accuracy is often among 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 that involve 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 can actually 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 back up the entries posted to its general 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. Stakeholders can count on this application, however, because the company will likely have to spend at least that amount to replace the goods if necessary.
Consistency is also a vital application of the cost principle. Companies must handle the same or similar transactions in the same way whenever they occur. For example, if a salon registers a new purchase of hair dryers as an asset, the same process should occur when purchasing replacement hair dryers. Failure to do so can distort a company’s financial information and distort financial statements. The consistency principle applies to all transactions.
The end result of the cost principle is a conservative approach to the accounting process. Using historical values may indicate 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 items in the financial statements.