The cost principle records goods and services at their original or historical cost, mainly used for short and long-term assets and liabilities. It is a conservative approach, but some believe it does not present the most accurate value. Current assets are carried at historical cost until sold, while long-term assets are recognized at historical cost and depreciated. Short-term liabilities are recognized at historical cost, while long-term investments are recorded at historical cost but may be revalued under mark-to-market accounting.
The cost principle is an accounting concept that goods and services should be recorded at their original or historical cost. This concept is mainly used when recording short-term and long-term assets and liabilities or equity investments. This concept takes a conservative approach when recording items in the company’s ledger. Detractors of the historical cost principle believe that this concept does not present the most current or most accurate value for balance sheet items. Although many educators and accounting theorists have criticized the historical cost principle, it is still the most widely used method of recording items in the ledger.
Current assets, such as inventory, short-term market papers and accounts receivable are carried at historical cost as this is the value at which these items are worth and can be sold in the open market. While the value of these items can change frequently in the open market, they remain on the books at historical cost until sold. Once sold, the company will recognize a gain or loss on these items depending on the sale price.
Based on the cost principle, long-term assets are recognized at historical cost and depreciated over the years or when the company uses the value of the asset. This usage is recorded as depreciation in the ledgers; the original long-term asset values are offset against total depreciation to determine the asset’s salvage value. The cost principle uses the salvage value of an asset as the future market value of the item. When a company sells long-term assets, any monetary difference above or below its salvage value is recognized as a gain or loss in the company’s books. Balance sheet liabilities are recorded in a similar way using this principle.
Short-term liabilities, such as payables or lines of credit, are recognized at historical cost as this represents the value of goods or services received by the company. Long-term investments or equity securities have traditionally been recorded at historical cost on a cost basis. Changes in accounting rules, mainly from mark-to-market accounting principles, changed the way companies recorded certain financial investment instruments. Mark-to-market accounting requires companies to revalue the historical cost of financial securities to current market values.
The revaluation of financial stocks occurs at specific intervals during the accounting cycle; companies must cancel or increase the value of these financial instruments. Market-to-market accounting creates a significant change in the cost principle of accounting. Companies are now forced to recognize gains and losses before selling financial stocks, by changing the value or wealth reported on the company’s balance sheet.
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