Cost Convention
Definition
Cost convention refers to the method used as a basis for recording costs that are charged against a company’s profit during an accounting period. The goal is to ensure accurate and consistent financial reporting. The cost convention can be categorized into three main types:
- Historical Cost: This convention records assets at their original purchase price. It provides a clear and verifiable number, reducing dispute risks but may not reflect the true economic value over time due to inflation.
- Current Cost: In this approach, assets are recorded based on their current market value. This helps in presenting a more realistic financial position but can introduce complications due to the volatility of market values.
- Replacement Cost: This method involves valuing assets at the amount it would cost to replace them with similar items at current prices. It reflects the cost of replacing the asset but involves estimating replacement costs, which can introduce subjectivity.
Examples
- Historical Cost Example: A business buys a truck for $30,000 in 2015. Even if the current value of the truck decreases over five years, it is still recorded at $30,000 in the financial statements.
- Current Cost Example: A firm buys land for $100,000. After five years, if the market price of the land rises to $150,000, the current cost method will reflect the land value at $150,000 in their financial statements.
- Replacement Cost Example: An entity purchases machinery for $50,000. Five years later, to purchase the same machinery, the business would need $60,000. The replacement cost method records the machinery at $60,000.
Frequently Asked Questions (FAQs)
Q1: Why is historical cost convention widely used? A1: Historical cost is widely used because it is objective and verifiable, reducing opportunities for manipulation. It provides consistency across reporting periods and is easier to apply.
Q2: What are the drawbacks of using the historical cost convention? A2: The primary drawback is that historical cost does not consider inflation or changes in market value, which can result in the financial statements not reflecting the current economic reality of an asset.
Q3: How does current cost differ from historical cost? A3: Current cost reflects the present-day market value of an asset, providing a contemporary view of its worth, unlike historical cost which records the asset at its original purchase price.
Q4: When is replacement cost convention particularly useful? A4: Replacement cost is particularly useful for industries where assets need regular replacement or where technology changes rapidly, ensuring the financial statements reflect the cost to replace assets accurately.
Q5: Does using replacement cost affect profit calculations? A5: Yes, because the depreciation expense based on replacement cost can be higher, leading to lower reported profits.
Related Terms with Definitions
- Fair Value: The price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.
- Depreciation: A method of allocating the cost of a tangible asset over its useful life. Depreciation represents how much of an asset’s value has been used up.
- Amortization: The process of spreading out a loan into a series of fixed payments over time. It also refers to the spreading out of capital expenses for intangible assets over a specific duration.
- Inflation Accounting: A variety of accounting methods designed to factor in the impact of inflation in the financial statements.
- Historical Cost Principle: An accounting method that requires assets to be recorded at their original purchase price, no matter how the market value changes over time.
Online Resources
- Investopedia - Cost Principle
- Accounting Coach - Historical Cost
- The Balance - Fair Value Accounting
Suggested Books for Further Studies
- “Financial Accounting: Tools for Business Decision Making” by Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso - This book offers a comprehensive introduction to financial accounting practices, including cost conventions.
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso - A foundational text on the guidelines and principles underlying effective accounting systems, relevant for understanding cost conventions.
- “Advanced Accounting” by Joe Ben Hoyle, Thomas Schaefer, and Timothy Doupnik - An in-depth resource for accounting students that delves into advanced topics such as inflation accounting and current cost accounting.
Accounting Basics: “Cost Convention” Fundamentals Quiz
Thank you for exploring the concept of cost convention with us. Keep enhancing your accounting knowledge and prepare to ace your exams!