The cost principle: What is it and how to use it effectively

Cost principle offers accurate information regarding the amount received from a sale. The numbers need to be the exact like the actual expenses from business transactions from a specific period. The basic accounting principle is that all the cost principle accounting information needs to be based on a cash or cash-equivalent principle.

What is the Cost Principle?

The cost principle means items need to be recorded as the actual price paid. It is the same way when a buyer buys products, and the recording is done based on the price paid. In short, the cost principle is equal to the amount paid for each transaction.

How is Cost Principle Applicable?

Giving a cost principle example can be tricky when there is no cash involved. The challenge comes in when you need to account for a trade-in and no cash is received. Like when a company uses their old car and trade-in for a new car. The record would be the new vehicle cost as the cash paid and the trade-in vehicle value.

Cost principle accounting emphasizes on having a record that is equal to the amount paid. The challenge is that the concept can interfere with the balance sheet. When dealing with fixed assets appreciation, the main problem comes when the value by the time of purchase differs from the current time. It becomes practical when dealing with depreciation and its effects on the business. 

Example of the Cost principle

 When there is a trade-in, a company can get a great deal of a car. The car might have a value of $20,000, but they pay $15,000 for it. When recording on the balance sheet, the company will use $15,000 as the actual amount paid even though the car has a value of $20,000. When issuing an invoice, it will still be the same amount as the cash received and not the car’s value.

 Why should you use the Cost Principle?

Cost principle concept applies to companies that use accrual accounting but wish to be GAAP compliant. Most of the public-owned companies apply GAAP in accounting; it is a requirement that they also use historical cost principle. Below find some of the benefits of applying cost principle in the business operations.

Benefits of Cost Principle Concept

1. This concept helps your balance sheet to be consistent. Historical cost principle helps to maintain consistency between each financial period. It becomes more practical when sharing with third parties, like lenders and investors.

2. You can use the cost principle concept to verify costs. In accounting, it is all about verification. All the transactions are done using any accounting software or manual ledger, and it is a requirement that you can verify that entry. If you need to verify your accounting books, the original sales document will act as evidence for the cost of the goods charged.

3. With this principle, there is hardly a time you will need to make any adjustments. When using the cost principle, there are minimum chances that the cost will change. Your financial statements will maintain accuracy and not depend on fluctuating fair values.

Business owners with no accounting background can use cost principles to achieve accuracy, consistency, and simplicity in their books. It is advisable to record your assets as per fair market value rather than the actual cost that might fluctuate. It offers accurate results during the financial period. It becomes easier to differentiate the cost of assets from the asset value.

There are different drawbacks to the cost principle concept; most of the time, large companies can witness the drawbacks. Most of these companies have investments in short-term and volatile securities. Are you looking to have easier accounting processes in your business?

Then, the historical cost principle is advisable for your business. In case you need expert advice, GoCardless can help you with ad hoc payments or recurring payments.