The cost principle is an accounting concept that requires companies to record costs at historical value. This avoids the use of market or fair values that can change in a short time period and create confusion on financial statements. Applications of the cost principle include accuracy, reliability, and consistency. The end result typically leads to a conservative approach for reporting financial figures. Both internal and external stakeholders rely on this information in order to make decisions and assess a company’s financial viability.
Accuracy is often among the most important applications for the cost principle. Companies must record transactions at the actual price paid for items in an arm's-length transaction. In most cases, all activities that involve the use of inventory, accounts receivable, or accounts payable require the application of this principle. Failure to do so can result in both inaccurate figures and inappropriately completed accounting activities for the company’s financial statements. The use of historical cost is not without controversy, however, as companies may actually underreport the value of their goods.
Reliability is also important when a company records costs. The application of the cost principle here indicates that a company has accurate records to back up the entries posted in its general ledger. An issue here, however, is that a company cannot usually replace the goods listed on its financial statement at the same cost. Inflation tends to increase the cost of goods in a market. Stakeholders can rely on this application, however, because the company will most likely have to spend at least this amount to replace goods if necessary.
Consistency is also a vital application of the cost principle. Companies must handle the same or similar transactions the same way every time they occur. For example, if a beauty salon records a new purchase of hair dryers as an asset, then the same process should occur when purchasing replacement hair dryers. Failure to do so can distort a company’s financial information and skew financial statements. The principle of consistency applies to every transaction.
The end result from the cost principle is a conservative approach to the accounting process. The use of historical values may indicate a company’s items at less than the current costs of replacement goods, but it will never show costs higher than the historical cost. Therefore, the company presents a conservative estimate for its total business. In some cases, however, a company may need to use the fair value principle for some items on the financial statements.
