What is cost concept in Accounting

Cost concept in Accounting-By this post, we shall study in detail the important cost concept out of 12 various accounting concepts on which accounting is based. If you have a business and you are doing cost valuation in accounting then you should know about this important cost concept.

What is the cost concept?

The cost concept is a concept of accounting which states that the value of an asset will be calculated on the basis of historical cost or acquisition cost. Such as an asset purchased at 25 lac in 1999 and same cost will be shown in 2022 financial statement in all future years.

How can you explain the cost concept?

As per this concept, the value of an asset is to be calculated on the basis of historical cost, in other words, acquisition cost. Although there are various measurement bases, accountants traditionally prefer this concept in the interests of objectivity.

When a machine is acquired by paying 5,00,000 then according to cost concept, the value of the machine is taken as 5,00,000. It is highly objective and free from all bias.

Other measurement bases are not so objective. Current cost of an asset is not easily determinable. If the asset is purchased on 1.1.1994 and such model is not available in the market, it becomes difficult to determine which model is the appropriate equivalent to the existing one.

Similarly, unless the machine is actually sold, realisable value will give only a hypothetical figure. Lastly, present value base is highly subjective because to know the value of the asset one has to chase the uncertain future.

Exemptions of the cost concept in Accounting

However, the cost concept creates a lot of misrepresentation too as shown below :

1. In an inflationary situation when prices of all commodities go up on an average, acquisition cost loses its relevance.

For example, a piece of land purchased on 1.1.1994 for 5,000 may cost 1,00,000 as on 1.1.2020. So if the accountant makes valuation of asset at historical cost, the accounts will not reflect the true position.

2. Historical cost-based accounts may lose comparability.

For example– Mr. S invested 1,00,000 in a machine on 1.1.1995 which produces 50,000 cash inflow during the year 2020, while Mr. N invested 5,00,000 in a machine on 1.1.2005 which produced 50,000 cash inflows during the year. Mr. S earned at the rate 50% while Mr. N earned at the rate 10%.

(3. Many assets do not have acquisition costs. Human assets of an enterprise are an example. The cost concept fails to recognise such asset although it is a very important asset of any organization.

Many other controversial issues have arisen in financial accounting that revolves around the cost concept which will be discussed at the advanced stage. However, later on we shall see that in many circumstances, the cost convention is not followed.

Example of cost concept?

As We know that according to this concept, the value of an asset is to be calculated on the basis of historical cost, in other words, acquisition cost.

Let’s take an example of a business that purchases a building worth 200,000 in cash or bank.

In the accounting records, following the cost concept of accounting, the value of the building will be entered at its cost price means 200000.

After four years, the value of the building rises to 1000,000. However, under the cost concept, the accounting records will continue to show the value of the building at the cost price of 200,000 less depreciation.

Historical cost is verifiable. It represents the cost that was objectively agreed upon by the buyer and seller. Hence, the basic objective of the cost concept is the measurement of accurate and reliable profits and losses for a business over a period of time.

Why cost concept is important?

1. Reliable:The process of showing historical cost on a business balance sheet is always the same. It doesn’t change hence it’s reliable. This is important because anyone looking at a balance sheet can get a reliable picture of the assets of the business.
2. Consistency: Using historical cost principle ensures that your balance sheet is consistent from period to period. This is even more important when sharing that balance sheet with outside entities, such as investors and lenders.
3. No adjustments required: As long as you consistently handle all your assets using the cost principle, costs will not change, always ensuring that your financial statements are accurate and not based on fluctuating fair values.
4. Comparable: It’s easy to compare the cost of one asset with another using the historical cost principle. This is important when making decisions about assets.
5. Verifiable: It’s also easy to verify historical cost because there are records underlying what’s showing on the balance sheet.

How does the cost concepts work?

1. An asset of a business is something in value that you buy for your business, like a laptop or furniture, and has two values:
   1. The cost (what you paid for it when you bought it) and
   2. Its value or fair market value (what you could get for it if you sold it).
2. The original cost can include everything that goes into the cost, including shipping and delivery fees, setup, and training. With a few exceptions (stocks and bonds, for example), all other business assets are recorded using the historical cost principle. These assets can be anything from equipment and computers to vehicles, land, and buildings.
3. The cost concept states that virtually all business assets must be recorded as the value on the date the asset was bought or assumed ownership.

Further Faqs related to cost concepts