Definition: The cost principle is an accounting concept that requires the numbers on the financial statements be based on actual expenses from business transactions incurred during the period. In other words, all accounting information must be measured on a cash or cash-equivalent basis.
What Does Cost Principle Mean?
The cost principle states that costis recorded at the price actually paid for an item. For example, when a retailer purchases inventory from a vendor, it records the purchase at the cash price that was actually paid. The cost is equal to the amount paid in the transaction.
This can be a little tricky if cash isn’t used in a transaction. For instance, what if an asset is traded for another asset? Many companies trade in older work vehicles for new ones on a regular basis. In this case, the company would record the cost of the new vehicle as the amount paid in cash plus the cash value of the trade-in vehicle.
As you can see, the cost principle emphasizes only recording costs that actually occurred for actual amounts paid. Sometimes this concept can distort the balance sheet. Especially for appreciating assets that were purchased years ago like real estate. Going back to our trade-in example, the company that traded in their car might have gotten a good deal on the new car. Instead of paying the full retail price of $30,000, it only had to pay $23,000. Even though the car is technically worth $30,000, the company records the cost on the balance sheet of $23,000 because that this is the amount that was actually paid for the car.
Some might argue that the assets on the balance sheet are understated because they reflect the historical cost instead of the market price, but historical cost is more reliable and objective than the market price.