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The cost principle is an accounting concept that states goods and services should be recorded at their original or historical cost. This concept is mainly used when recording short- and long-term assets and liabilities or equity investments. This concept takes a conservative approach when recording items into the company’s accounting ledger. Detractors of the historical cost principle believe this concept does not present the most current or most accurate value for balance sheet items. Even though many accounting educators and theorists have criticized the historical cost principle, it is still the most widely used method for recording items in accounting ledgers.
Current assets, such as inventory, short-term market securities and accounts receivable are recorded at historical cost since this is the value at which these items are worth and may be sold for in the open market. Although the value of these items may change frequently in the open market, they remain on the accounting ledgers at historical cost until sold. Once sold, the company will recognize a gain or loss on these items depending on the sale price.
Under the cost principle, long-term assets are recorded at historical cost and depreciated as the items age or the company uses up the value of the asset. This usage is recorded as depreciation on the accounting ledgers; original long-term asset values are netted against the total depreciation to determine the asset’s salvage value. The cost principle uses an asset’s salvage value as the future market value of the item. When a company sells long-term assets, any monetary difference above or below the salvage value is recognized as a gain or loss on the company’s accounting books. Balance sheet liabilities are recorded in a similar fashion using this principle.
Short-term liabilities, such as accounts payable or credit lines, are recorded at historical cost since 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 under the cost principle. Changes in accounting rules, mostly from the mark-to-market accounting principles, changed the way companies were recording certain financial investment instruments. Mark-to-market accounting requires companies to re-value the historical cost of financial securities to current market values.
Re-valuing financial securities occurs at specific intervals during the accounting cycle; companies must write off or increase the value of these financial instruments. Mark-to-market accounting creates a significant change in the cost principle of accounting. Companies are now forced to recognize gains and losses prior to selling financial securities, changing the value or wealth stated on the company’s balance sheet.
If it is understood that if the cost principle reflects the historical value of the cost, there should be no real issues. In other words, if everyone accounts for cost the same way, no one should have a problem interpreting it.
The changes in cost are reflected in different lines of the balance sheet, giving an investor a detailed idea of what the original cost was and how much that cost has depreciated or grown over time.