What is a Cost Basis?

Cost basis means the at-cost purchase price of an asset, including the incidental expenses, which is used to calculate tax arising from the gain or loss of an asset due to differences between the cost and current market price.

Cost Basis Calculation Formula

Cost basis followed by accounting standard and cost of an asset generally includes the following Cost = Purchase Price + Installation expenses incidental expensesIncidental ExpensesIncidental expenses are minor, non-budgeted expenses unrelated to primary service and do not arise during the normal course. Examples include employee business trip expenses such as food, lodging, hotel staff, tips to baggage carrier, gifts given to customers, newspapers, laundry services, etc.read more related to the purchase of an asset + Duty + Fee.

Example of Cost Basis Calculations

Cost basis can be determined differently under the following calculation examples.

#1 – Fixed Asset Purchase

Cost basis is calculated by the purchase price, installation expenses, expenses incurred for bringing an asset to their location and conditions. For example, X purchases machinery worth $ 10000, commission paid of $ 200. Transportation expenses are $ 100. The repair cost is $ 100; installation labor charges $ 100, duty, and taxes $50. The total cost of a fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more will be

$10000+$200+$100+$100+$100+$50=$ 10550.

#2 – Inventory

Cost is calculated differently for different levels of stock, such as For raw materials, the cost is calculated on the purchase price of materials. For Finished stock, the cost is calculated by adding raw materials and conversion costsConversion CostsConversion cost is incurred by any manufacturing entity in converting its raw material into finished goods sold in the market and includes labour cost and other applied overheads like factory overheads and administrative overhead. Conversion cost = manufacturing overheads + direct labourread more.

#3 – Investment

  • The long term investmentLong Term InvestmentLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets.read more is recorded on cost, and short term investmentShort Term InvestmentShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons.read more is recorded on cost or net realizable valueNet Realizable ValueNet Realizable Value is a value at which the asset may be sold in the market by the company after deducting the expected cost of selling the asset in the market. It is a crucial metric for determining the value of a company’s ending inventory or receivables.read more whichever is lower.Asset acquired by Gift, under this situation, cost of an asset is calculated on the fair value of the asset as suggested in Accounting Standard, which is relevant for income tax purposes to calculate the property tax of the asset.Suppose the fair value of the building is $ 200000, and it is transferred as a gift which has Nil consideration. Property tax is 10%.Property tax will calculate on fair value, i.e., $ 200000 by the income tax department, and the amount will be 10% of $ 200000 = $ 20000.

Types of Cost Basis

There are three types of cost basis methods that are followed in the organization.

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#1 – FIFO Method

  • This costing method refers to when stock is sold then we have a sale the first stock which acquired, it is known as the first in first out inventoryFirst In First Out InventoryUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read moreSuppose X purchased 10 stocks on 1st January and again on 2nd February 20 stocks. X sold 5 stocks on 3rd March. The organization will consider 5 stocks sold out of 1st January for recording purposes. This method generally is followed in perishable goods.

#2 – LIFO Method

This method is also known as last in first out accountingLast In First Out AccountingLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first.read more, and let’s consider the above example under this method organization will consider 5 stocks sold out of 2nd February.

#3 – Weighted Average Cost Method

This method records the value of the stock on an average cost basis. This method generally followed in mutual funds. Suppose 4 units purchased @$10 and 6 units purchased at $20.

The calculation will be [(4×$10)+(6× $20)]/4 units + 6 units = $16 average cost per unit.

Advantages

  • Cost basis important for tax purposes. For example, 100 shares purchased at $ 10 each, and the current market price per share is $ 50. Capital gains are 100 shares× ($ 50-$10) =$400The cost method is beneficial for financial reportingFinancial ReportingFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more purposes. Otherwise, it would be difficult for recording for those assets which are volatile. E.g., the market price of the share is volatile, and it changes every second if we start recording the transaction based on market price, then it would be difficult to maintain books according to such change.Cost basis differentiates which expenses should be added to cost or not. For example, as per accounting standard, it is mentioned that which expense will be included in the cost of the asset.Mr. X purchases a machine of $ 15000 and pays installation, brokerage, duty, fee, totaling $ 5000. He also pays some expenses not related to the asset of $ 500.

In this case, as per cost basis, the cost of assets will be $ 20000 because it is related to the purchase of assets. However, it will not include $ 500 to the cost of the asset because it is not related to the asset.

  • Cost Basis is essential to maintain tax balance across the country; otherwise, tax on short term capital gains will be as high as the income tax rate, which carries a lower tax rate as compared to income tax rates.Under the cost basis price of stock remain the same even if the share is splitShare Is SplitStock splits refer to the process whereby a company increases its number of shares, reducing the per-share price of the stocks. read more, which avoids unnecessary recording. For example, X purchased 100 shares at $1000 @ 10 each. Now the share split into 50 shares. The initial cost of $ 1000 will remain the same, but now the price for each share will be $ 20 instead of $ 10 each.

Disadvantages

  • A cost basis does not indicate the actual price of the asset. Suppose X purchased an asset which of $ 10000 and the same asset purchased by Y at $ 12000 As we can see, the cost of the same asset different is for X and Y for recording purposes.

Limitations

  • It is challenging for a large organization to identify and track the record of each item purchase date and which stock was purchased is to consider for sale.Under Cost basis, the sale price of a stock one of an organization can be cost price for another organization.For example, X sold stock to Y at $ 1000, which is the cost for Y. However, it is the sale price for X. Due to this reason how one can identify what the actual cost of a stock is.

Important Points

  • As per Accounting Standard change in method ofCost basis is a change in accounting estimate; proper disclosure is required to notes to the accounts.Any profit or loss arising due to change in method has to charge to profit and loss accounts.

Conclusion

The method of basis cost recording has to decide at the beginning of the financial year and consistently has to follow throughout the year. The company requires maintaining proper documentation for all purchases for quality and adequate control purposes.

This article has been a guide to What is a Cost Basis & its Definition. Here we discuss how to calculate cost basis along with examples, types, advantages, and disadvantages. You can learn more about from the following articles –

  • Cost-Based PricingCapitalization Cost ExamplesCost Per UnitRealized Gain