Cost principle is a standard accounting practice for publicly traded companies. Using cost principle follows the Generally Accepted Accounting Procedures (GAAP), which is established by the Financial Accounting Standards Board (FASB).
Alternate name: historical cost principle
An example of cost principle is a business purchasing a plot of land for $40,000 in 2019 that it planned to use as a parking lot. By 2022, the plot of land is valued at $80,000. The business would report the original cost of $40,000 on its financial statements, despite the asset appreciating in value.
How Cost Principle Works
When a business owner purchases something of value, such as land, a building, or equipment, it is defined as a business asset. As a business asset, it possesses two values: the original cost that was paid and the fair market value. Typically, short-term assets and liabilities are recorded using the cost principle method, since a business may not have possession of them long enough for their values to significantly change prior to their liquidation or settlement. The purpose of the cost principle is to ensure that financial statements record the original cost of a valuable asset. A company may not record what it estimates or thinks the value of the asset is, only what is verifiable. Recording the cost principle is essential because it is:
Consistent: The value originally recorded will never change despite an asset appreciating in value.Comparable: As a business owner, it is important to be able to make decisions concerning your assets. By using the cost principle, you will be able to see the original costs of all assets.Verifiable: Using the same value on all financial records is an uncomplicated and straightforward process of knowing a business’s assets. An accountant or bookkeeper will never need to refer to other documents to understand.
Since cost principle is a fundamental concept of accounting for businesses, it is important to understand its purpose in recording assets and how it assists accountants and bookkeepers with verifying information effectively. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
