Definition
The cost model is a method used in accounting to value fixed assets at their historical cost, which is the price paid to acquire them, minus any accumulated depreciation. This approach provides a straightforward and consistent way to calculate the book value of assets over time. The alternative to the cost model is the revaluation model, which periodically updates the asset values to their fair market value.
Section 17 of the Financial Reporting Standard applicable in the UK and Republic of Ireland (FRS 102) allows companies to choose between the cost model and the revaluation model. However, once a company selects a model, it must apply it consistently to all assets within the same class.
Examples
- Machinery:
- A company purchases a piece of machinery for $100,000. Using the cost model, if the machine’s useful life is estimated at 10 years with no residual value, the annual depreciation would be $10,000. After 5 years, the machinery’s book value would be $50,000 (initial cost $100,000 - accumulated depreciation $50,000).
- Buildings:
- A building is acquired for $500,000. Over a 50-year period, using straight-line depreciation, the annual depreciation expense would be $10,000. After 20 years, the building’s book value would be $300,000 ($500,000 - $200,000 of accumulated depreciation).
Frequently Asked Questions
Q1: What is the primary advantage of using the cost model?
- A1: The primary advantage is its simplicity and consistency. The historical cost is a verifiable figure, and the method ensures that financial statements can be easily understood and compared over different periods.
Q2: Can a company switch from the cost model to the revaluation model?
- A2: Once a model is chosen, a company must apply it consistently to all assets within the same class. However, with proper justification and reporting, switching models may be possible during a financial period, but it requires adherence to specific accounting standards and regulations.
Q3: Are intangible assets measured using the cost model?
- A3: Yes, intangible assets can be measured using the cost model, where they are valued at historical cost minus accumulated amortization and any impairments.
Q4: How does the cost model impact financial statements?
- A4: The cost model maintains asset values at the historical cost less depreciation, providing a conservative and stable approach to asset valuation that avoids market fluctuations.
Q5: Is the cost model allowed under IFRS?
- A5: Yes, under the International Financial Reporting Standards (IFRS), the cost model is an allowable method for measuring the value of fixed assets.
Related Terms
Fixed Assets
Tangible long-term assets used in the operations of a business, not for sale, and depreciated over their useful lives. Examples include properties, machinery, and equipment.
Historical Cost
The original cost incurred to acquire an asset. This cost is remained unchanged based on purchase price, excluding adjustments for inflation or market variations.
Accumulated Depreciation
The total depreciation expense that has been recorded for an asset since its acquisition, representing the reduction in value due to use and wear over time.
Revaluation Model
An alternative to the cost model where fixed assets are periodically revalued to their fair market value, reflecting current market conditions.
Depreciation
The systematic allocation of the cost of a tangible asset over its useful life. Depreciation can be calculated using methods like straight-line, declining balance, and units of production.
Online References
- Financial Reporting Standard (FRS) 102 - UK GAAP
- International Accounting Standards (IAS 16) – Property, Plant, and Equipment
- Accounting for Fixed Assets
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Financial Accounting and Reporting” by Barry Elliott and Jamie Elliott
- “Principles of Accounting” by Belverd E. Needles Jr., Marian Powers, and Susan V. Crosson
- “Fixed Assets and Depreciation Accounting” by Tim Ryan
Accounting Basics: “Cost Model” Fundamentals Quiz
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