The cost principle means that when putting an asset or liability on a companies balance sheet, the actual monetary cost of the asset/liability is used.
It is sometimes known as the historical cost principle because the cost of purchase is all important. Any change in market value or inflation is ignored.
For example, suppose a new machine is bought for £100,000. Then this will be listed on the balance sheet as an asset worth £100,000.
Appreciation and depreciation
Assets can both appreciate and depreciate. For example, a new printing machine may only be expected to last 5 years. In this case, the £100,000 asset will depreciate in value by £20,000 each year.
The balance sheet would list asset as £100,000. But each year £20,000 would be added to the depreciation account
Exceptions to cost principle
If a firm buys assets which are highly liquid and have a market value (e.g. government bonds) these should be listed at market value rather than historical cost.
Implications of cost principle
Google bought Youtube for $1.65 billion dollars in 2006. On Google’s balance sheet, the asset of Youtube is listed as $1.65 billion. However, by 2018, the value of Youtube is estimated at around $100bn (on 7 times revenue)
Google’s most valuable assets such as brand image and product loyalty will not be registered on the balance sheet.
Advantages of cost principle
- Easy and simple. It is straightforward to list the cost price of an asset.
- Because it is easy, it is the cheapest method of accounting. Also, it is not open to interpretation
Disadvantages of cost principle
- It may not reflect the underlying value of a business. For example, assets acquired at a cheap historical cost.
- Especially with the modern digital economy a lot of value, such as intellectual property and patents may be acquired at low or zero cost and so the firm appears to have limited assets. This could make it difficult for a firm to borrow for investment.