What is Meant By Cost Principle?

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Valuation of business assets can be a tricky endeavor. You may buy a simple piece of equipment that adds tremendous value to your company by speeding up production, saving you many times what you paid for it. Despite this extra layer of value, traditional accounting conventions require you to use the cost principle, valuing this asset in your books at the amount you paid for it.

Why Value at Cost?

The cost principle is a widely used accounting convention because it makes sense and provides consistency across bookkeeping for different businesses and for the same business across multiple years. Although valuing an asset at its cash price may sometimes be an oversimplification, the actual amount paid is an objective measure of its worth. If you are selling a business, referring to this principle gives you some guarantee that your asset list reflects your actual cash outlay. If you are buying a business, the cost principle can give you confidence that the seller is not inflating the worth of the physical assets you are buying.

What you Need to Know About the Cost Principle

Keep in mind that the cost principle is fundamentally an accounting convention. It reflects one aspect of the true value of your assets: the amount you paid for them. Using the cost principle gives legitimacy to your books and allows you to present your accounting information in ways that banks, investors and regulatory agencies understand. But the cost principle may not reflect the true value of an asset for your business, for example, if a piece of equipment saves you many times its initial cost by introducing production efficiencies. Use the cost principle whenever you need to present your books following strict accounting convention but find ways to emphasize other types of value when appropriate. For example, when presenting your company to investors, it is appropriate to point out the value of smart production systems even if these systems cost you very little to implement.

Keeping Track of Asset Costs

The cost principle is especially useful for depreciable assets or equipment and purchases that you deduct over time. To depreciate using the cost principle, choose a period to describe the useful life of the asset, such as 10 years. Use the actual amount you paid as the basis for depreciation, and then claim one-tenth of that cost as a depreciation deduction during each of the next 10 years. When listing this asset on your balance sheet, use the same logic and timeline to describe and assign its current value.

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About the Author

Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.