What Is Cost Principle?
Cost Principle states that an asset should always be recorded at the original buying price or cost and not the perceived value. Therefore, any changes in the asset’s market value should not affect how they are represented on the balance sheet.
The cost principle is an important aspect that businesses must follow when it comes to maintaining financial statements. It makes it mandatory for businesses to record raw asset prices, which marks its very original cost, unadjusted against any improvement or depreciation or with respect to the market value.
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Cost Principle Explained
A cost principle concept revolves around a significant aspect, which requires companies to record the prices of the assets that is equal to what their actual cost was at the time of purchase. This cost is not adjusted to any expense, be it the improvements done, or depreciation occurred. Plus, it ignores any kind of inflation in the value of the asset.
Financial investment should not be booked as per the cost principle. Instead, its value should get changed in each accounting period as per market value. In simple words, the financial records may get influenced enough to change the worth of the asset as per the improvement, depreciation, inflation, or other costs, including the market value, but the cost principle records still remain the same. This is what also makes it known as historical cost principle.
As per the Cost Principle in accounting, asset value should not get changed, but GAAP allows the asset value to change based on their fair value. This can be done using asset impairmentAsset ImpairmentImpaired Assets are assets on the balance sheet whose carrying value on the books exceeds the market value (recoverable amount), and the loss is recognized on the company's income statement. Asset Impairment is commonly found in Balance Sheet items such as goodwill, long-term assets, inventory, and accounts receivable. also. It is also known as the “historical cost principle.” The historical Cost Principle is better suited for short-term assets since their values don’t get changed much in a short time. For a fixed asset, accountants use depreciationAccountants Use DepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. , amortization, and impairment, etc.
Let us consider the following instances to understand the cost principle definition and its working:
Let’s say your firm has bought a machine. At the time of acquisition, the machine’s original cost was $100,000. Based on your business experience, you know that this machine can only work for the next ten years, and its value will be nil. So, initially, your fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. will get debited (increased by $100,000, and cash will get credited by $100,000.
The machine will work for only ten years, which means its fair value gets depreciated each year. So, next year, your accountant can use straight-line depreciationUse Straight-line DepreciationStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. and divide asset value by 10 to get depreciation value as $10,000 for each year. Next year, accounting for the asset will be the following:
There are other ways, such as impairment. Let’s say a company bought another company for $1 million. But after five years, the value of the acquired company suddenly dropped by half due to an issue. Then based on accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts., this company’s value can be impaired based on the current value.
Let us study two practical examples related to the cost principle.
Google acquisition of YouTube
The first cost principle accounting example is the Google acquisition of YouTube. In 2006, Google bought YouTube for $1.65 billion as one of the most significant tech acquisitions. As per Cost Principle in the book of Google, the value of YouTube will be shown as $1.65 billion.
However, years after the acquisition, YouTube’s value increased by many folds because of its popularity, and its base increased because of the rise in internet users and net speed. But in the books of Google, its value remains at $1.65 billion. Usually, if the asset’s fair value is higher, then companies won’t increase the value of the asset.
Infosys acquisition of Panaya and Skava
Now let us take Infosys’ acquisition of Panaya and Skava. In Feb 2015, Infosys bought two companies, ‘Panaya’ and ‘Skava,’ for USD 340 million. Since the closing of the acquisition, Infosys has struggled with this deal. Many allegations were thrown around about the deal, which has hampered these companies’ profiles because the fair value was reduced significantly.
In 2018, Infosys started reducing the value of these companies using additional amortization and depreciation. As of now, the current value of Panaya and Skava is shown as $206 million in Infosys books. This case shows that companies need to assess their assets regularly and fairly. If asset market value is going down, then in the books, their value needs to be reduced by additional depreciation, amortization, or asset impairment.
Cost principle is one of the most vital elements of accounting as it helps companies to record the initial price at which an asset was bought. Let us have a look at the advantages of the cost principle:
- Since assets need to be recorded at cost price hence, it is very easy to use. One just need to enter the cost of the asset in accountingAsset In AccountingAssets in accounting refer to the organization's resources that hold specific economic value and facilitate business operations, meet expenses, and generate cash flow. They create the company's worth and are recorded in the balance sheet. books.
- Since asset value is recorded as per books, that cost can be rallied back from the invoice or any other means. Hence, it can be easily verifiable.
- Since this is very easy to use, it is a much cheaper way to record the journal entries.
Cost Principle in accounting is easy to implement and cheap, but it has few limitations in terms of the fair value of an asset. Listed below are some of the limitations that one must know before implementing this principle of accounting:
- Since asset prices will be changed over the years, this method is not the accurate one as it does not show the asset’s fair value.
- This method also doesn’t show the value of intangible assets exampleIntangible Assets ExampleSome of the most common intangible assets are logos, self-developed software, customer data, franchise agreements, Newspaper Mastheads, license, royalty, Marketing Rights, Import Quotas, Servicing Rights etc., goodwill, customer value, etc. which could be a very crucial aspect of the asset. These intangible assetsThese Intangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. add a lot of value of the asset over time.
- If a company wants to sell its asset at that time of selling, there can be some confusion arising because the market value of that asset at which the company wants to sell will be quite different from the book value of the asset.
- This method is most suitable for short term assetsShort Term AssetsShort term assets (also known as current assets) are the assets that are highly liquid in nature and can be easily sold to realize money from the market. They have a maturity of fewer than 12 months and are highly tradable and marketable in nature..
- If an asset is highly liquid or has some market value, this method is not applicable. That asset should be listed as a market value rather than a historical costHistorical CostThe historical cost of an asset refers to the price at which it was first purchased or acquired..
- The company’s financial investment accounting should not be based on the cost principle. Instead, its value should be changed each accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. based on market value.
This has been a guide to what is Cost Principle. Here, we explain the concept along with its examples, advantages, and disadvantages. You can learn more about accounting from the following articles –