Explanation:
Advantage of cost principles
Ease of financial record-keeping
Because the cost principle is merely the initial cost of an asset, it can be much easier to keep a record of this initial value. This is because the historical cost principle only requires the initial cost of an asset, and a business may not need to continuously update its financial records to show current market values.
Objectivity
The historical cost principle refers to recorded values that are objective and verifiable as sales receipts, bank transactions or invoices, which are used to easily confirm the original value of an asset at purchase.
Cost of financial services
When a business employs a financial advisor or accountant, it might undergo additional expenses for these services. The longer an accountant works to verify and finalize a company's financial reports, the more it can cost the company. When tracking just the initial cost of an asset, an accountant may only need to verify the initial cost value of the company's assets. This can be quicker and much less taxing on resources than a full rendering of the company's accounts, ultimately saving the company extra costs when employing financial advisors or accountants.
The disadvantage of cost principles
Lack of accuracy
The cost principle can only take into account the initial value of an asset at the time a company acquires it. The cost principle may not take into account any increases in market value to the assets, nor can it report on the depreciation of the asset over time. Consequently, even if an asset is acquired at an original cost of $50,000, and that asset's market value increases over five years to $75,000, the cost principle will remain recorded at the initial value of $50,000.
Additionally, the cost principle does not account for depreciation, meaning that a decrease in the market value of an asset (like an automobile) may not affect the initial cost principle. This can ultimately harm a business, as the cost principle may not accurately represent any market loss the business has incurred.
Intangible assets may not be accounted
In addition to a lack of accuracy in accounting, the cost principle may also not take into account any intangible and valuable assets a company might possess. For instance, a company might hold valuable assets like brand identity, trademarks, intellectual property or goodwill from mergers or acquisitions. Because these assets are built up over time, a business may not be able to include their value within the initial cost principle.
Exceptions to cost principles
While most tangible assets can be considered in accounting for the cost principle, there are some instances where specific types of assets may not be considered when recording the historical cost principle. These exceptions may include:
A business's accounts receivable, as they might instead be recorded as realizable value, meaning these assets may not have been paid in full by customers or clients yet.
A business's highly liquid assets are expected to be converted to cash within a short time period, as these are typically recorded at their market value.
Any assets that have market-ready value, as these assets may be in the process of cash conversion and should be recorded at market value.
Any financial investments may be recorded at fair value throughout each accounting period.
