Cost Principle and its Elements
Cost Principle is one of the most basic guidelines that are applied in financial accounting. According to the cost principle, the assets should be determined mainly by their cost and in case the asset is new then the life of the new asset should be considered.
By life, the principles mean that companies should take into account the expected years within which the asset can work effectively. The cost principle cannot be applied to long-term assets or liabilities.
It is better to apply it to short-term assets and liabilities as anyone can hardly determine that what shape or direction a particular business would take in long-term. It is easier to identify the cost of an asset in a short-term rather than a long-term.
Problems of Cost Principle
However, financial accountants often face a lot of problems when it comes to applying the cost principle effectively. According to the cost principle, a companies brand name or logo cannot be considered, as an asset thus the most valuable asset that a company might have is not regarded as an asset that can help you reflect your financial situation.
Moreover, market trends and values of different assets tend to change over time so there can be a difference in the amount of the good at the time it was purchased as compared to the time during which it was sold.
The amount might not closely relate to the amount mentioned on your balance sheet. This can also lead to confusion in identifying the actual reality of your companies’ financial situation.
The issues can further aggravate if a company is trying to apply the cost principle to its long-term assets. The value of long terms assets can easily fluctuate with time. Thus the change in value can lead to confusion in terms of determining your financial situation.
It is easier to keep a check on the short-term assets, as their value is less likely to fluctuate as compared to long-term assets. In order to apply a cost principle, professional help from a financial accountant should be taken.
The conservatism principle is another element that is used in the concept of financial accounting. It guides on how different events or estimates can be recorded. According to the conservatism principle, there is always an error on the conservative side of any transaction that is done.
It is advised that the most conservative estimate should be used in order for the conservatism principle to work.
People should keep in mind that the conservative principle is not about keeping a track of your losses and profits but it actually refers to the concept of breaking ties while you are dealing with equally probable kinds of outcomes for different transactions.
Different businesses need to bear in mind that when different kinds of parties that are interested in your business are looking at your financial statements they want a to be assured that the company is not overestimating the profits it is making as that leads to a misleading situation and it might have an impact on reputation if the company.