Cost concept in accounting states that the assets should be recorded at the cost at which the business acquires them, i.e. historical cost. Under these concept, all the assets are recorded at the original cost irrespective of market value. This concept is also known as the Cost Principle or Historical Cost Concept. This concept focuses on objectivity and reliability in financial reporting, as the historical cost is verifiable and less subject to estimation.
Features of Cost Concept
1. Historical cost: Under this concept, assets are initially recorded at the actual cost. This cost includes the purchase price, taxes, transportation costs, and any other expenses directly attributable to bringing the asset to its present location and condition.
2. Objective: The cost is based on documentary evidence such as invoices and receipts, making it free from personal judgment or estimation. This makes financial statements more reliable and comparable.
Examples
- If a company purchases a piece of machinery for Rs50,000, it will be recorded in the balance sheet at Rs50,000, the same as its historical cost.
- A building bought for $1 million will be recorded at $1 million, even if its market value increases or decreases.
Advantages of Cost Concept
1. Reliability: Historical cost is supported by documents like bills and receipts, reducing bias.
2. Consistency: It ensures consistency in financial reporting by avoiding frequent revaluation of assets due to market changes or subjective estimates.
3. Comparability: Historical cost accounting makes it easier to compare financial statements across different periods and companies.
Limitations of Cost Concept
1. Value Relevance: Critics argue that historical cost may not reflect the true economic value of assets, especially when their market values change significantly. This can lead to an understatement of the asset value on the balance sheet.
2. Ignored Inflation: It does not consider the impact of inflation, which can erode the purchasing power of money over time. This can lead to an overestimation of the real value of certain assets.
3. Selective Applications: In some cases, historical cost may not be the most relevant measure. For example, in the case of investments in financial instruments, market values are often considered more informative.