Definition of Cost Principle
The cost principle is one of the basic underlying guidelines in accounting. It is also known as the historical cost principle.
The cost principle requires that assets be recorded at the cash amount (or the equivalent) at the time that an asset is acquired. Further, the amount recorded will not be increased for inflation or improvements in market value. (An exception is the change in market value of a short-term investment in the capital stock of a corporation whose shares of stock are actively traded on a major stock exchange.)
Example of Cost Principle
The cost principle means that a long-term asset purchased for the cash amount of $50,000 will be recorded at $50,000. If the same asset was purchased for a down payment of $20,000 and a formal promise to pay $30,000 within a reasonable period of time and with a reasonable interest rate, the asset will also be recorded at $50,000.
A long-term asset that will be used in a business (other than land) will be depreciated based on its cost. The cost will be reported on the balance sheet along with the amount of the asset’s accumulated depreciation. Further, the accumulated depreciation cannot exceed the asset’s cost.
The cost principle prohibits a company from recording an asset that was not acquired in a transaction. Hence, a company cannot report its highly successful management team as an asset nor can it report its highly valuable trademark that it developed over many years. (As a result of the cost principle, some of a company’s most valuable assets will not appear as assets on the company’s balance sheet.) On the other hand, if the company acquires a competitor’s trademark in a $3 million transaction, that trademark will be reported as an asset at its cost of $3 million.
