The cost principle is an accounting principle which states that an asset, liability, or equity should be recorded on a company’s book at the original acquisition cost.
The cost principle is an example of the concept of conservatism inherent in financial accounting. Thus, assets may be written-down, but reporting standards (in the U.S.) does not allow for most assets to be written-up to fair value.
For long-term assets, carrying amounts change over time, as the firm is required to depreciate fixed assets and amortize (certain) intangible assets. Such assets are also periodically tested for impairment and written-down if such an impairment is identified. Thus, the original acquisition cost is a starting point for an asset’s balance sheet value.
Not all assets are recorded at historical cost. For example, financial instruments such as stocks and bonds are accounted for at fair value as of the balance sheet date.
A variation of the cost principle is the lower of cost or market (LCM) method. The LCM method is used for valuing inventory. The method requires a firm to write down inventory should the selling value of the inventory dip below the inventory’s cost. The write-down is accomplished by crediting the inventory account and debiting the appropriate expense account.
The major shortcoming of the cost principle is that assets can be shown on a company’s books at values substantially below current market values.
