The cost convention, also known as the historical cost principle, is an accounting principle that requires assets to be recorded and reported at their original purchase cost. This convention ensures that financial statements provide a reliable and consistent measure of value, based on verifiable transactions. Here’s an in-depth look at the key aspects of the cost convention:
What is Historical Cost?
Assets are recorded at the amount paid to acquire them, which includes the purchase price plus any additional costs necessary to bring the asset to a usable state (e.g., installation, delivery)
When an asset is acquired, it is recorded at its historical cost in the accounting records. The asset remains on the books at this cost, regardless of changes in market value, unless specific accounting standards require revaluation (e.g., for impairments).
Impact on Financial Statements:
Assets are listed on the balance sheet at their historical cost minus accumulated depreciation or amortization for tangible and intangible assets, respectively. Liabilities are recorded at the amount of proceeds received in exchange for the obligation or at the amount expected to be paid to satisfy the liability.
Advantages of using historical cost basis:
- The historical cost is based on actual transactions, providing objective and verifiable data.
- Using historical cost ensures consistency in financial reporting over time, making it easier to compare financial statements across periods.
- It simplifies the accounting process since it avoids the complexities of continually revaluing assets based on market fluctuations.
Limitations:
- Historical cost may not reflect the current market value of an asset, which can be a limitation in times of significant price changes or inflation.
- For assets held over long periods, historical cost might not provide an accurate picture of an entity’s financial position or the true value of its assets.
Exceptions and Adjustments:
- Consider an asset’s market value falls below its book value and this decline is deemed to be permanent. In this case an impairment loss must be recognized to adjust the carrying amount.
- Certain financial instruments and other assets may be revalued to fair value as required by specific accounting standards (e.g., IFRS, GAAP).
Examples
Property, Plant, and Equipment : A company purchases a machine for $100,000. This amount, including installation and delivery costs, is recorded as the historical cost. Even if the machine’s market value increases or decreases, it remains on the books at $100,000 minus accumulated depreciation.
Inventory: Inventory is recorded at the purchase cost. If the market value of inventory drops below its cost, the inventory may be written down to the lower of cost or market value, following the principle of conservatism.
Conclusion
The cost convention is a fundamental principle in accounting that ensures assets and liabilities are recorded at their original purchase cost. This principle provides objectivity and consistency in financial reporting. Although it may sometimes limit the relevance of the reported values in reflecting current market conditions. Understanding and applying the cost convention is essential for accurate and reliable financial reporting.