A Study of the Cost Principle of Accounting

Cost principle recognizes that transactions are recorded as they occur in the money value at that time. The effect of recording these transactions at historical cost is that in both the revenue statement and the balance sheet there will be a mixture of cost incurred in various periods.

Accrual Principle recognizes of an expense for benefit received but not yet paid for, or the recognition of revenue that has been generated but for which cash has not yet been received.

Under the Accrual revenue is recognized in the period in which the inflow of economic benefits can be measured reliably and expenses are recognized when the consumption of goods or services is capable of reliable measurement.

Net profit for an accounting period is determined by subtracting expenses recognized during the period for revenues recognized in that period:

• An entity was organized in 1996 and received $ 100 000 in cash for in cash for services rendered before the end of the year. Assume also that its clients were charged $20000 for services completed in 1996 for which the cash is to be received in 1997.

  Revenue recognized in 1996 is $120 000 which is the sum of cash received ($100 000) and accounts receivable ($20 000) from customers for services rendered in 1996;

• For expense, salaries earned by employees in this period are reported as a current expense even though payment may not be made until the next period;
• In other cases prepayment of rent for the next period and the purchase of office equipment for cash, cash is paid before an expense is incurred;

To facilitate the preparation of the next period profit and loss statement all revenue and expense accounts are reduce to a zero balance at the end of accounting year process is also called closing the accounts only Balance sheet accounts are not closed their end of period end balance are carried forward and become the beginning balances of the next period.

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A basic problem with the Cost Principle of accounting is its inability to cope with changing price levels and the resultant changes in purchasing power per monetary unit over time. During periods of inflation the unit of money progressively purchases less as time goes by, and historical cost accounting does not recognize this.

Historical cost largely ignores these price changes and so does not disclose an up-to- date report of the net wealth and current income of the accounting entity concerned in times of changing price levels. In particular:

• Assets are reported in the balance sheet at the prices at which they were acquired (unless revalued), even though these prices may be completely out of date. For example, a block of land purchased in 1960 for $5000 and having a current market value of $100000 in 1997 can still be reported as an asset of S5000. The assets can therefore be seriously understated and lead to incorrect calculation of net assets. Expenses (including depreciation) used in earning profits are often based on out of date and low price, so that profit is overstated:
• If assets are understated and profits are overstated, a seriously optimistic exaggeration of rate of return of investment occurs. This destroys valid comparisons with the rate of return from alternative investment: and
• the loss of purchasing power that occurs through holding monetary assets and the gain in purchasing power through holding monetary liabilities is ignored. For example, if inflation was ten per cent per annum and a debtor owes $1000 for twelve months when the debtor pays at end of twelve months the $1000 will purchase fewer goods than it would have at the beginning of twelve months. The loss is one of purchasing power and can be quite significant in an entity with a high level of debt outstanding or cash held in the bank account.

In times of changing price levels, both reported income (revenue statement) and reported net wealth (balance sheet) calculated using the historical cost method do not reflect and report a factual account of events which occurred during and up the end of accounting period concerned. Historical cost accounting in times of changing has been recognized in Australia and overseas for some years, at present no one method has been accepted as suitable alternative.

However the professional accounting bodies in Australia now strongly recommend the Current Cost Accounting method (CCA) In their statement of Accounting practice on CCA (SAP1), as amended Feb 1989) state: to advance the adoption of improved accounting method to cope with the effects of changing prices, the accounting bodies strongly recommend that all entities publish CCA financial statement on a basis supplementary to conventional financial statement. The CCA statements would include a profit and loss statement, a balance sheet, a statement of change in shareholder equity, and explanatory notes. The CA method differ from the historical cost in number of ways. Profit under CCA is measured by increments in capital. The balance sheet is constructed to disclose the defined measure of capital by appropriate adjustments to items such as cost of goods sold, depreciation, gains and losses on holding monetary items, non-monetary assets bought and sold on the same market, investments in associated companies and foreign currency translation.