- Cost accounting records the value of large assets based on what a company paid for them at the time of their acquisition.
- Assets can be depreciated over time for additional tax benefits.
- Cost accounting can lead to substantial valuation of large assets at rates below fair market rates, thus creating a heavy tax burden if they are ever sold.
- This article is intended for entrepreneurs and professionals interested in accounting principles and software.
The cost principle is the idea that companies should value large fixed assets, like real estate and machinery, based on what the company paid for them at the time of acquisition, rather than their own. current fair market value. The cost principle is one of the four United States generally accepted accounting principles (GAAP) and is considered a more conservative (and potentially more accurate) way to value large assets.
Applying the cost principle maintains consistent and conservative values for your business assets. Unlike fair market value, which is often subjective and dependent on the market, the initial purchase price of an asset remains fixed over time. By applying the cost principle, you can keep your balance sheet consistent between periods and will not need to update your financial statements with current fair market values.
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How is the cost principle used?
The cost principle helps to ensure that a business’s assets are based on their actual cost rather than their value based on constant market fluctuations. The principle is most often reflected in a company’s balance sheet, which includes the values of all the assets it owns, as well as debts to sellers (including for business loans used to acquire assets).
To remember : When companies use the cost principle, they assign values to their large assets – such as real estate or equipment – equal to what they initially paid for the asset, regardless of when they l ‘purchased. While this does mean that the value they place on assets is stable over time, it can also be very conservative and sometimes inaccurate for assets purchased 10 or more years ago.
Exceptions to the cost principle
The cost principle is one of the more conservative ways of tracking the values of several large assets, but there are notable cases where cost accounting should not be used.
- Accounts receivable: Money owed to a business by its customers should not be recorded at the original amount owed. To be on the safe side, businesses should use the amount they expect to receive when the account is paid (the net achievable balance).
- Very liquid assets: If a business has assets for which there is a ready market (meaning the business can quickly sell the asset and turn it into cash), using the cost principle to value those assets may be overly conservative and make the balance sheet inaccurate. This is especially true for assets which, although liquid, can be held on a company’s books for long periods of time. Shares of publicly traded companies, for example, are usually valued at their fair market value (plus a possible discount if the company has to sell at a low loss).
Example of cost principle
To illustrate how the cost principle works, consider a small manufacturer who purchased a packaging machine for $ 100,000 in 2018. The asset is added to the company’s balance sheet for a value of $ 100,000.
In 2021, the fair market value of this equipment has increased to $ 130,000, due to higher prices for products manufactured by the manufacturer and supply chain issues to obtain this particular equipment. On a cost basis, the asset remains on the company’s books with a value of $ 85,000 ($ 100,000 less $ 15,000 in depreciation) and is not adjusted to reflect current market conditions.
Likewise, if the same company bought its manufacturing plant and land for $ 600,000 in 2000, real estate will remain on its books for the purchase price rather than its current market value of $ 3 million.
On the other hand, if the same company invested $ 200,000 in Tesla shares in 2017, the value of that liquid investment should be updated to reflect its current value after each accounting period. This is because the shares of a publicly traded company like Tesla are a very liquid asset and a common exception to the cost principle.
Advantages and disadvantages of cost accounting
Cost accounting allows businesses to itemize the true cost of expenses and is easy to manage from period to period. However, this method does not always accurately reflect the current value of assets and may result in your business being undervalued. Familiarize yourself with the pros and cons of cost accounting to better understand how items are reflected on your balance sheet and when to use cost accounting for your business. [Read related article: The Best Accounting Software Providers]
Advantages of the cost principle
The principle of cost is a popular accounting method because it is simple, straightforward and prudent. It allows businesses to easily identify, verify and manage expenses over time, without having to update asset values from period to period.
It details the actual costs for budgeting purposes.
By valuing assets at the price paid when they were acquired, companies are able to track changes in the cost of acquiring those assets over time and make budget decisions based on historical purchases and long-term trends. term of prices. They can also see how the value of their assets changes over time, which helps them make decisions about whether to purchase new or used equipment based on how the value of that equipment is likely to change. in the future.
Asset values are objective and can be easily verified.
One of the main advantages of cost accounting is its simplicity. All you need to know to use cost accounting is how much you paid for an asset. Of course, you can also depreciate fixed assets over time. The IRS describes amortization schedules for taxpayer use, and a trained accountant can implement them as well. Any depreciation of assets creates recurring tax benefits for businesses, as the depreciation can be offset against business income.
It does not require updating from period to period.
In addition to updating the values of impaired assets, cost accounting means that you don’t need to worry about updating the values of large assets on your balance sheet, even if they fluctuate over time. Cost accounting can also prevent you from overestimating the value of your assets, which is important if you are looking for financing or considering a merger or acquisition.
Disadvantages of the cost principle
In general, the disadvantages of cost accounting are greater for large companies than for small companies. This is especially true for companies with diverse and evolving product lines and those that are invested in volatile stocks. However, the cost principle has some shortcomings that can lead to undervaluation even of small businesses.
It does not accurately reflect the current value of an asset.
Some business equipment, like computers, is never worth more than what you paid for. But for many capitalized assets, like real estate or heavy equipment, the reverse is often true. Real estate is a good example. With values changing all the time, businesses that bought real estate five years ago could almost certainly get more for that property now. Yet cost accounting requires that they continue to value that asset at the price they paid for it, less any depreciation.
This can cause your business to be undervalued.
Since cost accounting often undervalues a company’s balance sheet assets, it can lead to a considerable undervaluation of the company itself. This can present difficulties when applying for business financing to expand your business, negotiating to merge or sell your business, etc. This means that it is essential to understand how cost accounting works and how it affects your specific situation, and to be able to explain your business finances to lenders and investors.
He may incur unexpected tax obligations.
When your business sells an asset, it will usually be sold for its fair market value rather than the price you paid for it. This difference is considered as a capital gain and is taxable up to the normal corporate tax rate.
This tax is particularly important for large assets which depreciate over time. If you sell an asset that has been depreciated for more than the value of the asset on your books, the resulting capital gain is called depreciation recapture and can result in a large and unexpected tax charge.
It does not take inflation or deflation into account.
One of the main drawbacks of cost accounting is that it ignores established long-term price trends for many large assets, including real estate. Due to inflation and other factors, the prices of many assets change over time in predictable ways. Cost accounting ignores these trends and instead values assets based on rigid cost principles. While this process can produce short-term tax benefits for your business, it can cause significant lags between your business’s balance sheet and long-term market prices.