Cost Convention

Cost Convention Financial Accounting Historical Cost Current Cost Replacement Cost Cost Accounting Profit
The cost convention refers to the basis used for recording costs charged against profit during an accounting period, which can be based on historical cost, current cost, or replacement cost.
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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:

  1. 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.
  2. 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.
  3. 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

  1. 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.
  2. 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.
  3. 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.

  • 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

Suggested Books for Further Studies

  1. “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.
  2. “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.
  3. “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

### Which of the following best describes historical cost convention? - [x] Recording assets at their original purchase price - [ ] Recording assets at their current market value - [ ] Recording assets at their replacement cost - [ ] Recording assets based on estimated future values > **Explanation:** Historical cost convention records assets at their original purchase price, providing a verifiable and consistent amount. ### What is the main advantage of using historical cost convention? - [ ] It accounts for inflation. - [ ] It reflects current market conditions. - [x] It is objective and verifiable. - [ ] It updates asset values automatically. > **Explanation:** The main advantage of historical cost is that it is objective and provides verifiable data, which helps in maintaining consistency across reporting periods. ### In which scenario is the replacement cost convention most beneficial? - [ ] When purchasing land - [x] When assets need frequent replacement - [ ] When recording employee salaries - [ ] When calculating short-term liabilities > **Explanation:** Replacement cost is most beneficial in scenarios where assets need frequent replacement, ensuring that financial statements reflect the current cost of replacing an asset. ### How does the current cost convention differ from historical cost? - [ ] It uses future values instead of past values. - [ ] It is the same as historical cost but uses inflation rates. - [x] It records the asset at its present-day market value. - [ ] It estimates asset values based on depreciation rates. > **Explanation:** The current cost convention records assets at their present-day market value, offering a contemporary view of its worth compared to the historical purchase price. ### What would be the recorded value of an asset under replacement cost convention if it cost $50,000 originally but now costs $60,000 to replace? - [ ] $50,000 - [x] $60,000 - [ ] An average of $55,000 - [ ] It remains unchanged irrespective of the market > **Explanation:** Replacement cost convention records the asset based on the amount it would cost to replace it with a similar asset at current prices, thus $60,000. ### Why might businesses not use current cost convention for financial reporting? - [ ] It is not approved by regulatory authorities. - [ ] It undervalues the assets. - [x] It introduces volatility due to changing market values. - [ ] It ignores historical purchase prices. > **Explanation:** Businesses might not use the current cost convention because it introduces volatility due to changing market values, which can make financial statements less stable. ### Which cost convention involves subjectivity due to estimation? - [ ] Historical Cost - [x] Replacement Cost - [ ] Current Cost - [ ] None of the Above > **Explanation:** Replacement cost involves estimation, which can introduce subjectivity as prices to replace assets are based on current market conditions and expected costs. ### Which cost convention is least affected by inflation? - [x] Historical Cost - [ ] Current Cost - [ ] Replacement Cost - [ ] All are equally affected > **Explanation:** Historical cost is least affected by inflation as it records assets at their original purchase prices, irrespective of market changes over time. ### Which principle helps ensure assets are not overstated in financial statements? - [ ] Current Cost Principle - [ ] Replacement Cost Principle - [x] Historical Cost Principle - [ ] Depreciation Principle > **Explanation:** The historical cost principle ensures that assets are not overstated in financial statements because they are recorded at their original purchase prices. ### Which method might require more frequent revaluation of assets? - [ ] Historical Cost - [x] Current Cost - [ ] Both Historical and Current Cost - [ ] Neither method > **Explanation:** The current cost method might require more frequent revaluation of assets to reflect their present-day market value, making it more dynamic and reflective of current conditions.

Thank you for exploring the concept of cost convention with us. Keep enhancing your accounting knowledge and prepare to ace your exams!

Tuesday, August 6, 2024
Cost Depletion
Cost Control Account
Cost January 1, 1
Cost Ledger Control Account January 1, 1
Current Cost January 1, 1
Direct Expense January 1, 1
Fixed Charge January 1, 1
Integrated Accounts January 1, 1
Interlocking Accounts January 1, 1
Replacement Cost January 1, 1
Unamortized Cost January 1, 1
Variable Cost January 1, 1

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