Question

Many non-accounting types argue that the cost concept is of little value because it does not reflect fair market value. Why is this?

Answer 1

Frame the answer using the following key points.

The cost concept of accounting states that all acquisition of items (such as assets or things needed for expending) should be recorded and retained in books at cost. Thus, if a balance sheet shows an asset at a certain value it should be assumed that this is its cost unless it is categorically stated otherwise. Under cost concept of accounting, an asset should be recorded on its cost in which it was purchased regardless of its market value.

-The obvious problem with the cost concept is that the historical cost of an asset, liability, or equity investment is simply what it was worth on the acquisition date; it may have changed significantly since that time.
- If a company were to sell its assets, the sale price might bear little relationship to the amounts recorded on its balance sheet. Thus, the cost concept yields results that may no longer be relevant, and so of all the accounting principles, it has been the one most seriously in question.

- This is a particular problem for the users of a company's balance sheet, where many items are recorded under the cost concept; as a result, the information in this report may not accurately reflect the actual financial position of a business.
-Some accountants have argued that in today’s inflationary environment, the gaining popularity, as is evidenced by many large companies, who now prepare supplementary information after taking into account the changes in the purchasing power. Nevertheless, historical cost concept continues to be used for the preparation of the primary financial statements.
- The cost concept implies that you should not revalue an asset, even if its value has clearly appreciated over time.
- This is not entirely the case under Generally Accepted Accounting Principles, which allows some adjustments to fair value. The cost concept is even less applicable under International Financial Reporting Standards, which not only permits revaluation to fair value, but also allows you to reverse an impairment charge if an asset subsequently appreciates in value.