What is the Cost Principle?

The cost principle requires you to initially record an asset, liability, or equity investment at its original acquisition cost. The principle is widely used to record transactions, partially because it is easiest to use the original purchase price as objective and verifiable evidence of value. A variation on the concept is to allow the recorded cost of an asset to be lower than its original cost, if the market value of the asset is lower than the original cost. However, this variation does not allow the reverse - to revalue an asset upward. Thus, this lower of cost or market concept is a crushingly conservative view of the cost principle.

Applicability of the Cost Principle

How the cost principle is applied depends on the situation, as noted below. The following three situations describe different applications:

Cost principle for short-term assets and liabilities. Using the cost principle for short-term assets and short-term liabilities is the most justifiable, since an entity will not have possession of them long enough for their values to change markedly prior to their liquidation or settlement.
Cost principle for securities. The cost principle is not applicable to financial investments, where accountants are required to adjust the recorded amounts of these investments to their fair values at the end of each reporting period.
Cost principle for long-term assets and liabilities. The cost principle is less applicable to long-term assets and long-term liabilities. Though depreciation, amortization, and impairment charges are used to bring these items into approximate alignment with their fair values over time, the cost principle leaves little room to revalue these items upward. If a balance sheet is heavily weighted towards long-term assets, as is the case in a capital-intensive industry, there is a greater risk that the balance sheet will not accurately reflect the actual values of the assets recorded on it.

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The Cost Principle and Asset Revaluation

The cost principle implies that you should not revalue an asset, even if its value has clearly appreciated over time. This is not entirely the case under Generally Accepted Accounting Principles, which allows some adjustments to fair value. The cost principle is even less applicable under International Financial Reporting Standards, which not only permits revaluation to fair value, but also allows you to reverse an impairment charge if an asset subsequently appreciates in value.

Problems with the Cost Principle

The obvious problem with the cost principle is that the historical cost of an asset, liability, or equity investment is simply what it was worth on the acquisition date; it may have changed significantly since that time. In fact, if a company were to sell its assets, the sale price might bear little relationship to the amounts recorded on its balance sheet. Thus, the cost principle yields results that may no longer be relevant, and so of all the accounting principles, it has been the one most seriously in question. This is a particular problem for the users of a company's balance sheet, where many items are recorded under the cost principle; as a result, the information in this report may not accurately reflect the actual financial position of a business.