The cost method of accounting for investments
/What is the Cost Method of Accounting for Investments?
The cost method of accounting is used to record an investment in another business when the investor has minimal influence over that business. More specifically, the cost method is used when the following two criteria are present:
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.
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Other Cost Method Rules
In addition to the points just noted, the following accounting rules also apply to the cost method:
If the investee pays dividends, the investor records them as dividend income; there is no impact on the balance in the investment account.
If the investee has undistributed earnings, they do not appear in any way in the records of the investor.
The Equity Method of Accounting
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, and involves a continuing series of entries, depending on the reported financial results of 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 of the investment.
Example of the Cost Method
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.