GAAP: Cost Principle

1. GAAP: Cost Principle Ashley Krystina Josh

2. Definition • The cost principle is one of the basic underlying guidelines in accounting • States that accounting for purchases must use the actual cost price to the purchaser, or historical cost, rather than current market value • No values may be created using guesswork, or wishful thinking, it must be the COST price • Values can be reduced through depreciation expenses

3. Affect on Current Assets • A current asset is something that can be converted to cash in 1 year at the most. (supplies, inventory items, electronics) • These are recorded at historical cost • The value of a current asset will remain the same on the accounting ledger until it is sold • After the asset is sold, a gain or loss is recorded, depending on the selling price

4. Example • A clothing store purchases sweaters for $30 each. After this, and because of the popularity, the supplier is now selling the sweaters for $50 a piece. Although the sweaters are now being sold for $50, the value for the sweaters in their inventory would still be recorded as $30, even though there was a price change to $50.

5. Affect on Long-Term Assets • A Long-term asset is an asset that will remain in a company’s balance sheet for one year or more. • This asset will be recorded at historical cost and depreciated over its useful life. • When the asset is no longer useful, it will be fully depreciated or any remaining cost will be a loss.

6. Example • A piece of land is purchased for $100’000. 7 years later, its estimated market value is $800’000. This is a big difference , but the value for this land asset must remain at $100’000 until sold. • A car costs $50’000 and it’s value drops to $10’000 in 10 years, so each year, $4000 will be debited to depreciation expense. The drop in value of $40’000 is divided among the ten years.

7. Pros of the cost principle • Easy to look back and refer to the original price • Less recording work is required, because the value of the asset is only manipulated at the end of each reporting period • Agrees with the conservatism principle, as depreciation expenses are applied when the asset is used and the value of an asset drops. • Conservatism always choses smaller values for assets. This ensures assets are not over valued.

8. Cons of the cost principle • Asset values do not represent current market values for the asset. If the asset is enhanced by the company and its value increases it will still be recorded at the original cost. • Opportunity costs are not recorded due to the use of an asset in the future. • Ex. If a machine you own could cost money to use and maintain in the future, these costs would be ignored until the transaction occurs.

9. Criticism • The cost principle has gotten a lot of criticism because it is considered irrelevant • Critics say that after an asset is purchased, the recorded value is no longer equivalent to the market value, or the actual current value • Historical cost for recorded values may have changed significantly since the date an asset, liability, or equity investment was originally acquired.

10. How can this help a business? • This principle helps to control the over-valuing of a businesses assets • It is a consistent rule for all companies to follow • Helps to distribute the cost of the use of an assets’ useful life • Better reflects the fair market value of most assets as it changes over time • Provides a stable, verifiable value for an asset

11. Other Information • Cost principle is less applicable to liabilities • If a balance sheet is heavily weighted on long-term assets, then there is more of a risk that the recorded values will not accurately reflect the assets actual values, as the market is constantly changing • You could get charged as a business owner or accountant for fraud, if you do not follow this principle, as the value of your company could become over-inflated by not following the rule