Cost Concept of Accounting
Cost Concept of Accounting: Definition
The cost concept of accounting states that all acquisitions of items (e.g., assets or items needed for expending) should be recorded and retained in books at cost.
Therefore, 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 at the cost at which it was purchased, regardless of its market value.
For example, if a building is purchased for $500,000, it will continue to appear in the books at that figure, irrespective of its market value.
Under this concept, stability in asset prices while recording is achieved. However, there are also some limitations to the cost concept of accounting.
For example, in the context of inflation, the cost concept of accounting would lead to an overstatement of net profit.
Despite its limitations, the cost concept of accounting is regarded as the best option when compared to the available alternatives.
The cost of an item may be different compared to its true value, but since figuring out the true value would be subjective, stating the assets at historical cost is generally accepted as a fair way to maintain records.
Following the cost concept of accounting means that unless there are special reasons for doing otherwise, the assumption should be made that the cost of an item is its true value, and all accounting entries should be made at cost.
Characteristics of the Cost Concept of Accounting
The cost concept of accounting can be characterized best by saying that for accounting purposes, all transactions are recorded at their monetary cost of acquisition (i.e., the price paid for acquiring an asset or receiving services).
To elaborate on this concept, if an asset does not cost anything (i.e., no money is paid for its acquisition), it would not be recorded in the company’s books.
For this reason, assets such as an organization’s technological skills, managerial capabilities, brands, and goodwill are not recorded as assets.
However, if the goodwill of another organization is purchased at a price, then following the cost principle, it will appear as an asset in the company’s balance sheet.
Notably, since assets are recorded at the cost of acquisition, any future increase or decrease in their values is not recorded in the balance sheet. However, an exception to this rule is the diminution in value that may arise from the depreciation of assets.
For example, suppose that a piece of land is acquired by a business at a specific price and, accordingly, is recorded as an asset in the books at that cost. Further suppose that the price of the land increases (e.g., twice the original cost in two years).
In the above example, if the cost concept of accounting is followed, the company’s balance sheet will always show only the acquisition cost and not the present worth or value of the land.
Since every end-user aims to know the value of an enterprise’s assets, it is logical to suggest that if the present value of assets is not shown in a balance sheet, then it fails to achieve the primary objective of communicating the worth of the enterprise.
Cost Concept and the Relevance Convention
It is worthwhile to ask why the cost concept of accounting is still adopted, especially given that it appears to be inconsistent with the relevance convention (i.e., because present values are relevant to most end-users).
There are several reasons for this. The primary one, of course, is that most people cannot agree on what an asset’s present value is, whereas the price paid as the asset’s acquisition cost is beyond dispute (in most cases).
Accordingly, recording assets at acquisition cost meets the convention of objectivity. Moreover, the present value of assets constantly undergoes change, meaning that if we were to record assets based on their present value, they would need to be updated practically every day.
This would introduce a degree of instability into the accounts, considerably reducing their effectiveness and acceptance.
Also, the cost of recording and updating asset values on a regular basis is time-consuming and expensive. Furthermore, the sources that are available for determining present values are diffused, which makes updating them challenging.
Accordingly, recording assets at cost meets the convention of feasibility. In particular, this is because 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 the long term and where their values undergo significant changes.
Any assets that are realized within a short time do not suffer from this problem.
Examples of such assets include cash, government securities, and amounts to be received from debtors. This is because, for these assets, their present values are practically identical to their acquisition cost.
Thus, it is occasionally the case that some fixed assets must be revaluated as a practical matter. Such revaluations, whether upward or downward, must 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 of accounting is best summarized 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.
Let’s consider the example of a business that purchases a building worth $100,000 in cash.
In the accounting records, following the cost concept of accounting, the value of the building will be entered at its cost price (i.e., $100,000).
After four years, the value of the building rises to $500,000. However, under the cost concept, the accounting records will continue to show the value of the building at the cost price of $100,000 less depreciation.
Historical cost is verifiable. It represents the cost that was objectively agreed upon by the buyer and 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 argue that in today’s inflationary environment, many large companies are preparing supplementary information after taking into account changes in purchasing power.
Despite this, historical cost continues to be used as a basis for preparing primary financial statements.