Accountancy · Ch 2 — Theory Base of Accounting
Cost Concept
Cost Concept
The cost concept is the rule that says an asset must be recorded in the books at the price actually paid to acquire it and make it ready for use. This price is called the historical cost. It is the total of everything spent to get the asset into a working condition at the business's premises.
For a purchased asset, the recorded cost includes:
- The purchase price (the amount paid to the seller).
- Cost of transportation (bringing the asset to the factory or office).
- Cost of installation (setting it up).
- Cost of repairs needed to make the asset usable (if it was bought in a non-working condition).
- Any other expense incurred to make the asset ready for its intended use.
The recorded cost is the sum of all these expenses. It is not just the purchase price alone.
Example from the textbook: Shiva Enterprise bought an old plant for ₹50,00,000. They spent ₹10,000 on transport, ₹15,000 on repairs to make it run, and ₹25,000 on installation. The total amount recorded in the books for this plant is:
₹50,00,000 (purchase) + ₹10,000 (transport) + ₹15,000 (repairs) + ₹25,000 (installation) = ₹50,50,000
This total of ₹50,50,000 is the historical cost of the plant. It will remain the same in the books year after year, even if the market value of the plant goes up or down.
Why is historical cost used?
The main reason is objectivity. The purchase price can be verified from the purchase invoice, receipt, or contract. Anyone can check the document and confirm the amount. Market value, on the other hand, is subjective — it can change every day and different people may estimate it differently. Using a verifiable, objective cost makes the accounting records reliable and consistent. It also makes comparisons between one year and the next meaningful, because the asset's value in the books does not fluctuate with market changes.
Limitation of the cost concept
The biggest drawback is that the balance sheet does not show the true worth of the business. An asset bought for ₹2.5 crore may be worth ₹5 crore in the market after a few years, but the books will still show it at ₹2.5 crore. This understates the business's real financial strength. …