What Is the Cost Principle?

How is the cost principle used?

The cost principle helps ensure business assets are based on their actual cost rather than their value based on the market’s constant fluctuations. The principle is most often reflected in a company’s balance sheet, which includes values for all of the assets it owns, as well as debts owed to vendors (including for business loans used to acquire assets). 

Exceptions to the cost principle

The cost principle is one of the most conservative ways to track the values of multiple large assets, but there are some notable cases where cost accounting should not be used.            

• Accounts receivable: Money owed to a business by its customers should not be recorded at the original amount owed. To be conservative, companies should use the amount they expect to receive when the account is paid (the net realizable balance).
• Highly liquid assets: If a business owns assets for which there is a ready market (meaning the business can quickly sell the asset and turn it into cash), using the cost principle to value these assets may be too conservative and make the balance sheet inaccurate. This is especially true for assets that, though liquid, may be held on a company’s books for long periods of time. Shares of stock in publicly traded companies, for example, are typically valued at fair market value (plus a possible discount if the company needs to sell at a small loss).  

Example of the cost principle

As an illustration of how the cost principle works, consider a small manufacturer that purchased a packing machine for $100,000 in 2018. The asset is added to the company’s balance sheet with a value of $100,000. 

In 2021, the fair market value of that equipment has gone up to $130,000, due to higher prices for goods that the manufacturer is making and supply chain issues in getting that particular piece of equipment. Under the cost principle, the asset remains on the company’s books with a value of $85,000 ($100,000 minus $15,000 in depreciation) and is not adjusted to reflect the current market conditions. 

Similarly, if the same company purchased its manufacturing facility and land for $600,000 in 2000, the real estate will remain on its books for the purchase price rather than its current market value of $3 million. 

On the other hand, if the same company invested $200,000 in Tesla stock in 2017, the value of that liquid investment should be updated to reflect its current value after each accounting period. This is because stock in a publicly traded company like Tesla is a highly liquid asset and a common exception to the cost principle. 

Pros and cons of cost accounting

Cost accounting enables businesses to detail the actual cost of expenditures and is easy to maintain from period to period. However, this method doesn’t always accurately reflect the current value of assets and may result in your business being undervalued. Familiarize yourself with the pros and cons of cost accounting to better understand how items are reflected on your balance sheet and when to use cost accounting for your business. [Read related article: The Best Accounting Software Providers]

Advantages of the cost principle

The cost principle is a popular accounting method because it’s simple, straightforward and conservative. It lets businesses easily identify, verify and maintain expenses over time – without having to update the value of assets from period to period. 

It details actual costs for budgeting purposes.

By valuing assets at the price paid when they were acquired, businesses are able to track how the cost to acquire those assets is changing over time, and to make b3udgeting decisions based on historical purchases and long-term trends in price. They can also see how the values of their assets are changing over time, which helps them make decisions about whether to buy equipment new or secondhand based on how the value of that equipment is likely to change in the future.

Asset values are objective and can be easily verified.

One of the biggest advantages of cost accounting is its simplicity. All you need to know in order to use cost accounting is how much you paid for an asset. Of course, you can also depreciate any capitalized assets over time. The IRS outlines depreciation schedules for taxpayer use, and a trained accountant can also implement them. Any depreciation of assets creates recurring tax benefits for business, as depreciation can be offset against the business’s income.

It does not require updating from period to period.

Aside from updating the values of depreciating assets, cost accounting means you do not need to bother updating the values of large assets on your balance sheet, even if they fluctuate over time. Cost accounting can also prevent you from overestimating the values of your assets, which is important if you’re seeking financing or considering a merger or acquisition.

Disadvantages of the cost principle

In general, the drawbacks of cost accounting are more significant for larger companies than for small businesses. This is particularly true for businesses with diverse and ever-changing product lines and those that are invested in volatile securities. However, the cost principle does have some shortcomings that may result in even small businesses being undervalued.

It does not accurately reflect an asset’s current value.

Some business equipment – like computers – are never worth more than what you paid for it. But for many capitalized assets, like real estate or heavy equipment, the opposite is often true. Real estate is a prime example. With values changing all the time, companies that purchased real property even five years ago could almost certainly get more for that property now. Yet cost accounting requires that they continue to value that asset at the price they paid for it, less any depreciation.

It may result in your business being undervalued.

Because cost accounting often undervalues the assets on a business’s balance sheet, it can lead to the business itself being dramatically undervalued. This can present difficulties when applying for business financing to expand your business, negotiating to merge or sell your business, and so on. This means it’s critical to understand how cost accounting works and how it impacts your specific situation, and to be able to explain your business’s finances to lenders and investors.

It can incur unexpected tax liabilities.

When your business sells an asset, it will typically be sold at fair market value rather than the price you paid for it. This difference is considered a capital gain and is taxable at up to normal corporate income tax rates. 

This tax is especially significant for large assets that depreciate over time. If you sell an asset that has been depreciated for more than the value of the asset on your books, the resulting capital gain is called depreciation recapture and can lead to large, unexpected tax liability.

It doesn’t account for inflation or deflation.

One of the biggest drawbacks of cost accounting is that it ignores established long-term pricing trends for many large assets, including real estate. Because of inflation and other factors, the prices of many assets change over time in predictable ways. Cost accounting ignores those trends and instead values assets based on rigid cost principles. While this process can produce short-term tax benefits for your business, it can lead to significant misalignments between your firm’s balance sheet and market prices in the long run.