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The Cost Principle

The cost principle requires that assets on the financial statements of an entity be recorded at historical cost. Cost refers to the amount of cash (or cash equivalents) spent to originally obtain the asset, or the proceeds (cash or cash equivalents) received when a liability was originally written. 

The key take-away from this rule is that assets are not to be written up when they increase in value, even as a result of inflation. The impetus for this rule stems from the 1929 stock market crash. Leading up to the crash, it was a frequent practice for accountants to appraise capital assets - the values of which eventually came crashing down. The Securities Act of 1934 was enacted soon-after. Arguments for historical cost accounting ascertain that this cost-basis allows firm's to present an accurate picture of the current installment of the firm's earning power, which would provide better information for investors. 

Today, there are exceptions to the historical cost principle, and we use what is called a 'mixed measurement system.' That is, while most financial statements today are frequently characterized as being based on historical cost, there are certain classes of assets and liabilities that are less accurately portrayed as 'historical cost' - for example, trade receivables, notes payable and warranty obligations.1

A Mixed-Measurement System

The most important reason today for an exception to the historical cost rule is the principle of conservatism. This principle requires that accountants must disclose anticipated expenses or losses, but does not allow a similar action to be taken for anticipated revenues or gains. For example, inventory may be writen down if its net realizable value is less than its historical cost, but it cannot be writen up to an amount higher than historical cost. This allows for assets and liabilities to be reported on the financial statements on five different basis:

1. Historical cost: property, plant and equipment and most inventories are reported at their historical cost, and liabilities are reported at the amount of their historical proceeds, and may be adjusted after acquisition for amortization

2. Current (replacement) cost: some inventories are reported at their current (replacement) cost, which is the amount of cash that would have to be paid for equivalent assets today. 

3. Current market value: some investments in marketable securities are reported at their current market value, because they can be immediately liquidated. Current market value may also be used for assets that are expected to be sold for less than their previous carrying amount. 

4. Net realizable (settlement) value: short-term receivables and some inventories are recorded at net realizable value if the proceeds from when these assets are to be sold are expected to be less than their previous carrying value. 

5. Present (or discounted) value of future cash flows: long-term receivables and long-term liabilties are reported at their present value. In the oil and gas industry, proven reserves are also reported at present value. 


Reference:

1. FASB CON5 - 19