Definition Definition

Cost Principle: Advantages & Disadvantages of Cost Principles with Example

What is Cost Principle?

Cost Principle, also known as the Historical Cost Principle is one of the basic underlying guidelines in accounting, dedicates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. 

Understanding Cost Principles

The cost principle suggests that assets should be valued at their actual value rather than market value. Since the price of an option is often changeable depending on market dynamics, that is why the cost principle is applied in different situations. For instance, a property you bought a year ago could unexpectedly increase in value due to various factors. It's possible that the maker has discontinued producing that asset, or that it's got expensive.

Current assets, such as financial institutions, have little effect on the cost principle because they are short-term securities with little potential for growth. Whereas, materials and technical parts should be documented at the original amount and kept on the financial statements at their original price.

Advantages of Cost Principles

The benefits of using the cost principle are as follows-

  • Financial statements are consistent: The historical cost concept assures that your financial statement remains consistent over time.
  • Verifying costs: There has to be an original record for every step you take in your accounting systems or with your traditional ledger accounts.
  • No changes that need to be made: Expenditures would not fluctuate as long as you regularly manage all of your assets according to the cost principle, guaranteeing that your balance sheets are correct and not dependent on changing market values.

Disadvantages of Cost Principle

While there are obvious benefits to utilizing the cost principle, there are still a few drawbacks and they are -

  • The company's significant symbols or trademarks will not be recorded in the financial statements.
  • When selling an item, problems can occur since it will most likely be purchased at market price rather than its actual cost.
  • Finally, depending on historical asset costs, the worth of your firm may be significantly undervalued, which can have a significant effect on your credit profile, capacity to receive a loan, and even your opportunity to sell the business.

Practical Example

If JBL purchases land for $30,000, the company initially reports it on the balance sheet at $30,000. But what does the company do if, by the end of next year, the land had increased in value to $40,000? 

Under the cost principle, it continues to report the land at $30,000. So, the guideline requires the assets to be recorded at the cash amount (or its equivalent) at the time that an asset is acquired.

In Sentences

  • The cost principle dictates that an item, obligation, or equity investment be recorded at its original value.
  • Cost principle does not apply to investment portfolios, which involve accountants modifying the stated values to their actual costs at the end of each accounting period.


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