Business owners must be mindful of their accounting principles to increase cash flow and reduce potential risks. One way to solidify your financial situation is by adhering to the cost principle, which states that assets should be recorded at the amount initially paid rather than the current market value. Understanding the importance of this concept will set you on the right path towards avoiding bankruptcy and deliver other benefits such as accurately determining profit and having meticulous bookkeeping practices. In this blog post we will discuss how applying the cost principle for recording expenses helps ensure long-term success for small businesses. Keep reading to find out more about how it works and why it’s so important!
Table of Contents
1. What is the cost principle?
2. Example of the cost principle
3. Cost principle Vs fair market value
4. Conclusion
5. FAQs
What is the cost principle?
The cost principle, also known as the historical cost principle, is one of the most fundamental principles in accounting. It is a principle that governs the recording of assets in financial statements, and it is essential for businesses of all sizes to understand and apply it correctly.
The cost principle requires that assets are recorded in financial statements at their original cost, which is the amount paid to acquire them. This means any changes in an asset’s value over time, such as appreciation or depreciation, are only considered once the asset is sold or disposed of.
Example of the cost principle
Example 1
As per the cost principle in accounting, when a company acquires a building for $500,000, it must be recognized on the balance sheet at its original cost of $500,000, regardless of any fluctuations in its market value after the purchase. Similarly, when a company procures inventory for $10,000, the cost principle necessitates that the inventory be recorded on the balance sheet at its original cost of $10,000, regardless of any changes in its market value.
The cost principle is a vital accounting principle that advocates a cautious approach to accounting grounded in factual transactions rather than estimates or assumptions concerning the value of assets. This method fosters precision and dependability in financial reporting, which is critical in making informed business decisions.
Example 2
In this scenario, assume that your company has acquired a machine with an original cost of $160,000. Given the estimated useful life of the machine of ten years, it is expected that its value will be fully depreciated by the end of its useful life. Therefore, an initial journal entry would be made, debiting the fixed asset account and increasing it by $160,000, while crediting the cash account for the same amount. This entry ensures that the cost of the asset is properly recorded and recognized in the financial statements, enabling accurate financial reporting and effective decision-making.
| Item | Debit | Credit |
|---|---|---|
| Fixed Asset | $160,000 | |
| Cash | $160,000 |
The useful life of the machine is limited to ten years, and its fair value depreciates annually. Therefore, applying the straight-line depreciation method, the accountant can divide the asset value by ten to obtain a depreciation value of $16,000 for each year. The subsequent year’s accounting for the assets will reflect this depreciation expense.
| Item | Amount |
|---|---|
| Machine | $160,000 |
| Depreciation | $16,000 |
| Net Machine value | $1,44,000 |
Example 3
In accounting, impairment is another method to account for changes in the value of an asset. For instance, if a company purchases another company for $1 million and after five years, the value of the acquired company declines by 50% due to unforeseen circumstances, the current value of the company can be impaired based on accounting principles.
Cost principle Vs fair market value
The principles of cost and fair market value hold significant importance, particularly in the valuation of assets and liabilities. The cost principle emphasizes the historical costs incurred in acquiring an asset or incurring liability, whereas fair market value pertains to the current market conditions that affect the value of an asset or liability.
| Criteria | Cost Principle | Fair Market Value |
|---|---|---|
| Basis for the Valuation | Historical cost of an asset | Current market value of an asset |
| Recording Assets | Assets recorded at the original cost, regardless of any changes | Assets recorded at current fair market value |
| Assets Under Consideration | Assets that have not undergone significant changes in value | Assets subject to fluctuations in value over time |
| Purpose of Valuation | Internal reporting purposes | External reporting, such as financial statements to investors |
| Accuracy of Information | Provides simplicity and stability in financial reporting | Provides more accurate information on the current asset value |
Conclusion
The cost principle is essential to keep an accurate record and report financial transactions, control costs, comply with regulations, and provide valuable financial analysis. Failure to follow this principle can result in incorrect financial reporting, which can mislead investors and creditors, ultimately leading to bankruptcy. To mitigate such risks, IBN Tech specialist offers reliable outsourced accounting services that cater to the full spectrum of accounting operations. Our professionals utilize a suite of accounting software programs such as QuickBooks Online, Xero, FreshBooks, and Sage Business Cloud Accounting, among others, to keep track of assets and other business activities, ensuring the completeness and accuracy of financial records.
FAQ’s
- Q.1 What is the cost principle in accounting?
- The cost principle is a fundamental accounting principle that requires companies to record their assets at the historical cost at the time of acquisition, rather than at their fair market value.
- Q.2. How does the cost principle help to avoid bankruptcy in businesses?
- The cost principle is an accounting principle that requires businesses to record their assets at the original cost of acquisition, rather than their current market value. By following this principle, businesses can avoid overstating their financial position, which can prevent them from making bad investment decisions that could lead to bankruptcy.
- Q.3 How does the cost principle contribute to financial reporting accuracy?
- The cost principle provides a reliable and objective basis for financial reporting, as it reflects the actual costs of acquiring and bringing the assets to their intended use. By following the cost principle, businesses can avoid overvaluing their assets and misrepresenting their financial position, which is crucial for investors and creditors to make informed decisions.
