Explanation of Cost Principle-Accounting

Componenets of the asset side of the Federal Reserve System balance sheet from January 4, 2007 to September 25, 2008. This is the assets of all 12 Federal Reserve Banks combined as reported by the Federal Reserve. (Photo credit: Wikipedia)

Que es el principio de conservatismo?

El principio de conservatismo ayuda al contable ha decidir entre 2 alternativas .For example, if an item in inventory has a cost of $20, but it can be replaced for $15, the conservatism principle directs the account to report the item in inventory at $15 and to immediately report the loss of $5. For an asset such as inventory it means reporting the lower asset amount on the balance sheet and the lower net income amount on the income statement. From the conservatism principle comes the accountants’ the lower of cost or market rule for inventory valuation.The conservatism principle does not say that accountants are to be conservative. Accountants should be fair and objective. The conservatism principle is used to “break a tie” between two reasonable options. It is not intended to motivate accountants to beat down a company’s earnings and assets.

What is the cost principle?

The cost principle is one of the basic underlying guidelines in accounting. It is also known as the historical cost principle.
The cost principle requires that assets be recorded at the cash amount (or its equivalent) at the time that an asset is acquired. For example, if equipment is acquired for the cash amount of $50,000, the equipment will be recorded at $50,000. If the equipment will be useful for 10 years with no salvage value, the straight-line depreciation expense will be $5,000 per year (cost of $50,000 divided by 10 years). The equipment’s market value, replacement cost or inflation-adjusted cost will not affect the annual depreciation expense of $5,000. The company’s balance sheets will report the equipment’s historical cost minus the accumulated depreciation.

The cost principle also means that valuable brand names and logos that were developed through effective advertising will not be reported as assets on the balance sheet. This could result in a company’s most valuable assets not being included in the company’s asset amounts. (On the other hand, a brand name that is acquired through a transaction with another company will be reported on the balance sheet at its cost.)
If a company has an asset that has a ready market with quoted prices, the historical cost may be replaced with the current market value on each balance sheet. An example is an investment consisting of shares of common stock that are actively traded on a major stock exchange.

Samples of Acounting Transactions

Sample Transactions 

Sample Transaction
Marilyn illustrates for Joe a second transaction. On December 2, Direct Delivery purchases a used delivery van for $14,000 by writing a check for $14,000. The two accounts involved are Cash and Vehicles (or Delivery Equipment). When the check is written, the accounting software will automatically make the entry into these two accounts.

Marilyn explains to Joe what is happening within the software. Since the company pays $14,000, the Cash account is credited. (Accountants consider the checking account to be Cash, and the TIP you learned is that when cash is paid, you credit Cash.) So we know that the Cash account will be credited for $14,000 and we know the other account will have to be debited for $14,000. We need only identify the best account to debit. In this case we choose Vehicles (or Delivery Equipment) and the entry is:

Account Name

Debit

Credit

Vehicles

14,000

Cash

14,000

The balance sheet will look like this after the vehicle transaction is recorded:

Direct Delivery, Inc. Balance Sheet December 2, 2011 Assets Liabilities & Stockholders' Equity Cash $   6,000 Liabilities Vehicles 14,000 Stockholders' Equity                Common Stock $ 20,000 Total Assets $ 20,000 Total Liab. & Stockholders' Equity $ 20,000

The balance sheet and the accounting equation remain in balance:

Assets	=	Liabilities	+	Stockholders' (or Owner's) Equity
$20,000	=	$0	+		$20,000

As you can see in the balance sheet, the asset Cash decreased by $14,000 and another asset Vehicles increased by $14,000. Liabilities and stockholders' equity were not involved and did not change.



Sample Transaction
The third sample transaction also occurs on December 2 when Joe contacts an insurance agent regarding insurance coverage for the vehicle Direct Delivery just purchased. The agent informs him that $1,200 will provide insurance protection for the next six months. Joe immediately writes a check for $1,200 and mails it in.

Let's consider this transaction. Using double entry, we know there must be a minimum of two accounts involved—one (or more) of the accounts must be debited, and one (or more) must be credited.

Since a check is written, we know that one of the accounts involved is Cash. Since cash was paid, the Cash account will be credited. (Take another look at the last TIP.) While we have not yet identified the second account, what we do know for certain is that the second account will have to be debited.

At this point we have most of the entry—all we are missing is the name of the account to be debited:

Account Name

Debit

Credit

whats the name

1,200

Cash

1,200

We know the transaction involves insurance, and a quick look through the chart of accounts reveals two possibilities:

Prepaid Insurance (an asset account reported on the balance sheet) and Insurance Expense (an expense account reported on the income statement)

Assets include costs that are not yet expired (not yet used up), while expenses are costs that have expired (have been used up). Since the $1,200 payment is for an expense that will not expire in its entirety within the current month, it would be logical to debit the account Prepaid Insurance. (At the end of each month, when $200 has expired, $200 will be moved from Prepaid Insurance to Insurance Expense.)

The entry in the general journal format is:

Account Name

Debit

Credit

Prepaid Insurance

1,200

Cash

1,200

After the first three transactions have been recorded, the balance sheet will look like this:

Direct Delivery, Inc. Balance Sheet December 2, 2011 Assets Liabilities & Stockholders' Equity Cash $   4,800 Liabilities Prepaid Insurance 1,200 Stockholders' Equity Vehicles    14,000 Common Stock $ 20,000 Total Assets $ 20,000 Total Liabilities & Stockholders' Equity $ 20,000

Again, the balance sheet and the accounting equation are in balance and all of the changes occurred on the asset/left/debit side of the accounting equation. Liabilities and Stockholders' Equity were not affected by the insurance transaction.