Cost Principle: What Is It?

DEFINITION

The accounting rule known as the "cost principle" states that any assets owned by a company will be valued at their original cost rather than the current market price. The purpose of using the cost principle method is to maintain reliable information across financial documents and provide consistency in verifying an asset’s cost at the time of purchase.

Definition and Examples of Cost Principle

Cost principle is the accounting practice of recording the original purchase price of an asset on all financial statements. This historic cost of an asset is used to provide reliable and consistent records. A cost principle will also include expenses incurred in purchasing the asset, such as shipping and delivery fees, as well as setup and training fees.

Cost principle is a standard accounting practice for publicly traded companies. Using cost principle follows the Generally Accepted Accounting Procedures (GAAP), which is established by the Financial Accounting Standards Board (FASB).

• Alternate name: historical cost principle

An example of cost principle is a business purchasing a plot of land for $40,000 in 2019 that it planned to use as a parking lot. By 2022, the plot of land is valued at $80,000. The business would report the original cost of $40,000 on its financial statements, despite the asset appreciating in value.

How Cost Principle Works

When a business owner purchases something of value, such as land, a building, or equipment, it is defined as a business asset. As a business asset, it possesses two values: the original cost that was paid and the fair market value.

Typically, short-term assets and liabilities are recorded using the cost principle method, since a business may not have possession of them long enough for their values to significantly change prior to their liquidation or settlement.

The purpose of the cost principle is to ensure that financial statements record the original cost of a valuable asset. A company may not record what it estimates or thinks the value of the asset is, only what is verifiable.

Recording the cost principle is essential because it is:

•Consistent: The value originally recorded will never change despite an asset appreciating in value.

•Comparable: As a business owner, it is important to be able to make decisions concerning your assets. By using the cost principle, you will be able to see the original costs of all assets.

•Verifiable: Using the same value on all financial records is an uncomplicated and straightforward process of knowing a business’s assets. An accountant or bookkeeper will never need to refer to other documents to understand.

Since cost principle is a fundamental concept of accounting for businesses, it is important to understand its purpose in recording assets and how it assists accountants and bookkeepers with verifying information effectively.

Key Takeaways

•Cost principle, also referred to as historical cost principle, is an accounting practice that records the original purchase price of assets on financial statements despite fluctuating market changes.

•The concept of cost principle is one of the five Generally Accepted Accounting Procedures (GAAP), which is established by the Financial Accounting Standards Board (FASB).

•The purpose of cost principle is to easily identify the original value of an asset on financial documents.

•Exceptions to the cost principle rule of recording assets are stocks and bonds, which are recorded at their fair market values.

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