Cost PrincipleExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

When a company purchases an asset, it will record the value of that asset at its initial purchase price in the company’s financial reports.

This value is the cost principle, and for many businesses, the cost principle will be used to record the value of the business’s tangible assets.

This value will not be changed over time to reflect the changes in the asset’s market value.

We will be discussing the cost principle, how it is used, and give some examples of its use in this article.

What is the Cost Principle?

The cost principle states that businesses should record assets at their original cost.

After the business records the asset value, it will not be changed to reflect any increases in market value, improvements in the asset, or to consider any depreciation.

Short and long-term assets, as well as liabilities and equity, can be recorded at historical cost, then all of these will always be recorded at their initial cost.

A business’s financial records often keep track of the depreciation or increase in the value of its assets.

But, the cost principle of these assets will stay the same.

The cost principle is also known as the historical cost principle.

This means that even if an asset appreciates or depreciates in value over time, the cost principle will still be the initial cost of the asset when it was acquired.

Cost Principle Advantages

Because the cost principle is so easy to use, there are some advantages businesses may find when using this principle.

The cost principle makes it easy for a business to objectively record the cost of an asset and to track an asset’s cost.

It also can save the company money when it uses financial services to help determine the value of its assets while using the historical cost principle.

Simple Financial Record-Keeping

When using the cost principle, a business only records the asset’s initial cost.

This makes it a lot easier to maintain a record of the asset’s initial value.

Businesses can easily do this since the historical cost principle only requires an asset’s initial cost to be recorded.

Therefore, companies might not be required to update their records over time to keep track of the asset’s current market value.

Objectivity

When a business uses the historical cost principle to record the value of an asset, the value will be objective and easy to verify.

Since the value is the original price of the asset when it is purchased, it can easily be verified through an invoice, bank transfer, or sales receipt.

Lower Financial Services Costs

If a company hires an accountant or a financial advisor, they might find that they are charged additional fees for certain services.

If it takes an accountant a long time to prepare a business’s financial statements, it will cost a business more money.

However, if a business uses the cost principle for a number of its assets, it may take an accountant less time to verify the cost of the business’s assets, thus saving the business money.

Cost Principle Disadvantages

The cost principle does have two major disadvantages.

One disadvantage the cost principle has is that it does not always provide the most accurate information on the overall financial status of a business.

Another disadvantage is that the cost principle might not account for assets that a business has purchased slowly over a period of time instead of by an upfront purchase.

Problems With Accuracy

The cost principle only considers an asset’s value when a business acquires it.

This principle might not consider the increases in market value to an asset over time or the depreciation of the asset over a period of time.

Therefore, if a business buys an asset for $100,000 and the market value of this asset increases to $150,000 during the next five years, the cost principle of this asset will still be recorded at its original purchase price of $100,000.

Another problem with the cost principle is it does not take into account the depreciation on an asset.

This means that although an asset’s market value may decline over time, this might not be reflected in the cost principle.

Unfortunately, this might not be good for a business because the cost principle might not correctly reflect a market loss incurred by a company.

Cost Principle May Not Account for Intangible Assets

Beyond some problems with accuracy when using the cost principle, the cost principle might have the additional issue of not accounting for valuable, intangible assets a business owns.

A business could have valuable assets, such as trademarks, goodwill, brand identity, or intellectual property.

However, since these intangible assets built up in value over time, a company may find they cannot include this value in the asset’s initial cost principle.

Cost Principle Exceptions

Although businesses can use the cost principle of accounting for recording many tangible assets, not all kinds of assets can be recorded using the historical cost principle.

Some assets should not be recorded using historical cost, such as:

• Accounts receivable should not be listed at historical costs. They should be recorded at their realizable value because customers may have not yet paid their account in full.
• Financial investments
• Assets that have market-ready value should be recorded at their market value instead of historical cost because they are quite possibly already in the process of being converted into cash.
• Highly liquid assets should also not be recorded using historic cost since they will likely soon be exchanged for cash. These assets should be recorded at their market value.

Examples

We will now give some examples of assets that a business can record using the historical cost principle.

Historical cost is the price a business paid for an asset when they originally purchased it.

The first example we give will consider the original cost of an asset and its appreciation over a period of time.

Whereas the second example will consider an asset’s cost and its depreciation over time.

Example One

Bob’s Posters and Prints bought a new building in 2017 in order to open up another store.

The building cost $60,000. In 2021, the appraised value of the building was $65,000.

However, the business will likely not change the cost principle because the increase in value is due to the increasing market value of the property.

Rather than changing the cost principle, the business may credit this difference to an equity account.

By doing this, the cost principle will continue to reflect the original purchase price the business paid for the building instead of the increased value.

Example Two

Bob’s Posters and Prints bought 3 printers for $2,500 each.

The printers were recorded individually, which meant six cost principle entries for $2,500 each.

The printers are estimated to have a useful life of five years with a residual value of $250 each at the end of this time.

The business’s balance sheet will show the cost principle for the printers as being $2,500 each even as depreciation decreases the value of the printers to a $250 market value at the end of the printers’ five-year useful life.

The business could have a depreciation account in which they allocate the depreciation for the printers during each of the years the printers are being used.