Cost Method Overview
When an investing entity makes an investment and the investment has the following two criteria, the investor accounts for the investment using the cost method:
- The investor has no substantial influence over the investee (generally considered to be an investment of 20% or less of the shares of the investee).
- The investment has no easily determinable fair value.
Under these circumstances, the cost method mandates that the investor account for the investment at its historical cost (i.e., the purchase price). This information appears as an asset on the balance sheet of the investor.
Once the investor records the initial transaction, there is no need to adjust it, unless there is evidence that the fair market value of the investment has declined to below the recorded historical cost. If so, the investor writes down the recorded cost of the investment to its new fair market value.
If there is evidence that the fair market value has increased above the historical cost, it is not allowable under Generally Accepted Accounting Principles to increase the recorded value of the investment. This is a highly conservative approach to recording investments.
Other Cost Method Rules
In addition to the points just noted, the following accounting rules also apply to the cost method of accounting for investments:
- If the investee pays dividends, the investor records them as dividend income; there is no impact on the investment account.
- If the investee has undistributed earnings, they do not appear in any way in the records of the investor.
The alternative method of accounting for an investment is the equity method. The equity method is only used when the investor has significant influence over the investee. It is considerably easier to account for investments under the cost method than the equity method, given that the cost method only requires initial recordation and a periodic examination for impairment.
Cost Method Example
ABC International acquires a 10% interest in Purple Widgets Corporation for $1,000,000. In the most recent reporting period, Purple recognizes $100,000 of net income and issues dividends of $20,000. Under the requirements of the cost method, ABC records its initial investment of $1,000,000 and its 10% share of the $20,000 in dividends. ABC does not make any other entries.