Cost concept of accounting
What is Cost Concept of Accounting? – Definition
The cost concept of accounting states that all acquisition of items (such as assets or things needed for expending) should be recorded and retained in books at cost. Thus, if a balance sheet shows an asset at a certain value it should be assumed that this is its cost unless it is categorically stated otherwise.
Under the cost concept of accounting, an asset should be recorded on its cost in which it was purchased regardless of its market value e.g. If a building is purchased for $5,00,000, it will continue to appear in the books at that figure irrespective of its market value. Under this concept stability in prices of assets while recording is achieved. There are also some limitations of this concept e.g. in case of inflation there will be an overstatement of net profit etc. Above all its limitations this concept is considered to be the best one when compared with alternatives.
The cost of an item may well be different from its true value but since ascertainment of true value would be judgmental and therefore subjective, stating assets at historical cost is generally accepted as fairway of maintaining records.
Following the cost concept means that unless there are special reasons for doing otherwise cost of an item should be assumed to be its true value and that all accounting entries should be made at cost.
Characteristics of Cost Concept of Accounting
The cost concept can best be characterized by saying that for purposes of accounting, all transactions are recorded at their monetary cost of acquisition, i.e. the price paid for acquiring the asset or for receiving the services provided. To elaborate on this concept, if an asset does not cost anything, i.e. no money is specifically paid for its acquisition, it would not be recorded in the books of accounts of the company. It is for this reason that the technological skills built up inside an enterprise, the managerial or technical capabilities of an organization, the goodwill of a company or the brand name of a product, are hot recorded as assets. However, if the goodwill of another organization is purchased at a price, then following the cost principle, it will have to appear as an asset in the balance sheet of the company.
It is of interest to note that since assets are recorded at acquisition costs, as a rule, any subsequent increase or decrease in their values would not be recorded in the balance sheet. An exception to this statement is the diminution in value arising from the depreciation of assets. However, suppose a piece of land is acquired by a business enterprise at a particular price and is accordingly, recorded as an asset in the books of accounts of the enterprise at that cost. Subsequently, the price of land shoots up—say, five years later the value of the land is twice the original cost.
The balance sheet of the company will continue to show only the acquisition cost and not the present worth or value. Since all end-users are interested in knowing the value of the assets owned by a business enterprise, it would be logical to argue that a balance sheet would fail to achieve the primary objective of communicating the worth of the enterprise, if the present value of its assets is not shown in the balance sheet.
Cost Concept and the Relevance Convention
Why, then, is this concept which is inconsistent with the relevance convention (since present values are relevant to most end-users) still adopted? There are several reasons for this. The primary one, of course, is that most people cannot agree on what is the present value of an asset while the price paid in terms of money as the acquisition cost of the asset is beyond dispute in most cases.
Accordingly, the recording of assets on acquisition cost basis meets the convention of objectivity. Moreover, the present value of assets constantly undergoes change with the result that if we were to record the assets on the basis of their present value, we would require to alter them practically every day. This would introduce a degree of instability in the accounts which would considerably reduce their effectiveness and acceptance.
Furthermore, the cost of recording values on a continuing basis would be so time-consuming and expensive, and the sources for determination of present value would be so diffused that it would be extremely difficult to record present values and to change them continuously. Accordingly, the recording of assets at cost meets the convention of feasibility, the money paid to acquire an asset is easily ascertained and recorded without too much effort.
It should be noted that the cost concept creates problems only in relation to assets that are held by the business enterprise for use over a long term and where their values undergo significant changes. Those assets which are realized within a short time do not have this problem, e.g. cash, government securities, amounts to be received from debtors, etc., because, in the case of these assets, their present values are practically identical with their acquisition cost. Thus, occasionally in the case of some fixed assets revaluation has to be done as a practical matter.
Such revaluations (whether upwards or downwards) have to be disclosed in terms of the amount and date of the revaluation for a subsequent period of five years.
The position relating to the cost concept is best summarised as follows:
Value, as used in accounts, signifies the amount at which an item is stated, in accordance with the accounting principles related to that item. Using the word value in this sense, it may be said that balance sheet values generally represent cost to the accounting unit or some modification thereof; but sometimes they are determined in other ways, as for instance on the basis of market values or cost of replacement, in which cases the basis should be indicated in financial statements, The word value should seldom if ever be used in accounting statements without a qualifying objective.
For example, a business buys a building worth $1,00,000 in cash. In the accounting records, the value of the building will be entered at its cost price, i.e. $1,00,000. After four years, the value of the building goes up to $5,00,000. However, the accounting records would continue to show the value of the building at the cost price of $1,00,000 less depreciation.
Historical cost is verifiable. It represents the cost that was objectively agreed upon the buyer and the seller. Hence the basic objective of the cost concept is the measurement of accurate and reliable profits and losses for a business over a period of time. However, some accountants have argued that in today’s inflationary environment, the gaining popularity, as is evidenced by many large companies, who now prepare supplementary information after taking into account the changes in the purchasing power. Nevertheless, historical cost continues to be used for the preparation of the primary financial statements.