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What is the Cost Principle?

November 10, 2015​

Questions about GAAP:

What is the cost principle and why is it important?

Facts:

The cost principle states that you record an asset or liability at its original acquisition cost or purchase price.

Discussion:

The cost principle is one of the Generally Accepted Accounting Principles (GAAP). GAAP is basically the rule book that accountants follow for preparing financial statements. Assets are recorded at their original purchase price known as historical cost. For example, if a corporation buys equipment for $50,000, it will be recorded at $50,000. If the equipment will be useful over 5 years with no salvage value, it will be depreciated at a rate of $10,000 per year for 5 years. The company’s Balance Sheet will report the historical cost of equipment less the accumulated depreciation. As the fair market value of assets can change significantly over time, the historical cost always remains the same and is the value recorded on the financial statements.

Land as an example is not a depreciable asset and it usually appreciates over time. As a result, an asset amount recorded at historical cost does not reflect the amount of money a company would receive if it were to sell the asset. One exception to this rule is an asset such as marketable security that is publicly traded. The historical cost may be replaced with the current market value on the Balance Sheet. However, since marketable securities fluctuate significantly over time, it may be a better option to leave the carrying value at its historical cost.

Capital assets are required to be written down if circumstances change and their value drops below their carrying value. Inventory may also be written down as the value of the original item may have decreased over time. Inventory is recorded at the lower of cost or net realizable value, which is the market selling price less any costs to sell the goods. Although the cost principle is not always relevant to the current market value of assets or liabilities, it is useful to managers, investors and bankers to make important decisions. GAAP allows the readers of the financial statements to review meaningful and comparable information.

If you would like more information on this topic, please contact a member of the Empire CPA team by filling out the contact form below.

Canadian and foreign tax laws are complex and have a tendency to change on a frequent basis. As such, the content published above is believed to be accurate as of the date of this post. Before implementing any tax planning, please seek professional advice from a qualified tax professional. Empire, Chartered Professional Accountants will not accept any liability for any tax ramifications that may result from acting based on the information contained above.

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