What is Cost Principle?

Explain how cost principle applies in the workplace and work life.

Cost Principle is the monetary value of a product, service, or resource given by the cost of the monetary value of the resources used to produce it. In other words, the principle states that the total costs of a product should equal the total monetary value of the resources used to produce it. While there are many factors that affect Cost Principle, there are three main factors that are important to understand: time, labor, and materials. Cost Principle is closely related to the Marginal Cost principle.

Home Accounting Blog Cost Principle: Explanation, advantages and disadvantages

4. May 2021
Adam Hill Accounting Blog

Definition

In financial reporting, the historical cost convention requires that assets, liabilities and investments be recorded at their monetary value at the date of their creation or acquisition, regardless of whether the cost changes over time. That is why it is also called the historical principle.

In other words: According to this principle, we do not book transactions based on what we think they are worth. We base our value on financial transaction data and take into account historical costs. Example: Casey’s purchased an office in 2017 for $130,000 and the office space will cost $190,000 by 2020. Casey needs to reflect the value of the office on the balance sheet. Casey would put the value of the office at $130,000, although it has changed over the years to meet the value principle.

Professional

The application of this principle has several advantages. Firstly, it is simple and makes it easy to record transactions. It is also considered more consistent, comparable and reliable because it can be backed up with evidence. The use of a valuation basis that differs from the historical value can be problematic for companies. If you z. B. by using current market value rather than historical cost, each auditor may propose a different cost amount for each asset held by the entity.

Moreover, current market values are not appropriate for companies that prepare their financial statements more frequently than annually. This can happen when calculating net income or preparing the balance sheet on a monthly basis, because we would then have to determine a new sales value for the asset at the end of each month, which is extremely inconvenient.

Cons

What’s wrong with the cost principle that companies have to follow? The first problem is accuracy, as costs can fluctuate over time. Accordingly, the information in the financial statements may not be relevant because the acquisition cost and current market value may differ significantly.

Moreover, not all assets are recorded according to this principle. It applies to z. B. not for investment. In this case, the auditor must adjust the amounts of these investments in the accounts to their fair value at the end of each period.

The historical cost principle also has a negative impact on the actual financial situation of the company. When an entity wishes to sell assets, the sale price may have little relationship to the amounts reported in the financial statements.

Since the financial situation can be significantly distorted, this is probably the most debatable principle of accounting. The application of the cost principle to current assets and liabilities would be justified because the entity has not held these items on its balance sheet long enough for their value to change significantly.{“@context”:”https://schema.org”,”@type”:”FAQPage”,”mainEntity”:[{“@type”:”Question”,”name”:”What is the meaning of cost principle?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The cost principle is a principle in economics which states that the cost of production is the price of the finished product.”}},{“@type”:”Question”,”name”:”What is cost principle example?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The cost principle is the idea that the cost of a product is the sum of the costs of the individual components.”}},{“@type”:”Question”,”name”:”Why is the cost principle used?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The cost principle is used because it is the most appropriate principle when the cost of an activity is not known.”}}]}

Frequently Asked Questions

What is the meaning of cost principle?

The cost principle is a principle in economics which states that the cost of production is the price of the finished product.

What is cost principle example?

The cost principle is the idea that the cost of a product is the sum of the costs of the individual components.

Why is the cost principle used?

The cost principle is used because it is the most appropriate principle when the cost of an activity is not known.