Cost Method Explained: Accounting & Investment Strategies

The cost method of accounting is used for recording certain investmentsInvestment MethodsThis guide and overview of investment methods outlines they main ways investors try to make money and manage risk in capital markets. An investment is any asset or instrument purchased with the intention of selling it for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends). in a company’s financial statements. This method is used when the investor exerts little or no influence over the investment that it owns, which is typically represented as owning less than 20% of the company. The investment is recorded at historical cost in the asset section of the balance sheet.

 

 

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How Does the Cost Method Work?

The investor reports the cost of the investment as an asset. When dividend income is received, it is recognized as income on the income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or. The receipt of dividend also increases the cash flow, under either the investing section or operating section of the cash flow statement (depending on the investor’s accounting policies).

If the investor later sells the assets, he or she realizes a gain or loss on the sale. This affects net incomeNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through in the income statement, is adjusted for in net income on the cash flow statement, and affects investing cash flow.

The investor may also periodically test for impairment of the investment. If it is found to be impaired, the asset is written down. This affects both net income and the investment balance on the balance sheet.

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Simple Example

Traderson Co. purchases 10% of Bullseye Corporation for $1,000,000. At the end of the year, Bullseye announces it will be paying out a dividend of $100,000 to its shareholders.

When Traderson purchases the investment, it records the investment of Bullseye at cost. The journal entries may appear as follows, depending on Traderson’s investment strategy and history. It may classify the investment differently, depending on the type of marketable securityMarketable SecuritiesMarketable securities are unrestricted short-term financial instruments that are issued either for equity securities or for debt securities of a publicly listed company. The issuing company creates these instruments for the express purpose of raising funds to further finance business activities and expansion. it deems, but it will generally classify it as an asset.

Dr.Trading Securities1,000,000Cr.Cash1,000,000

 

At the end of the year, Traderson receives 10% of the $100,000 dividends (as Traderson holds 10% of Bullseyes shares)

Dr.Cash10,000Cr.Dividend Revenue10,000

 

What are the Other Accounting Methods?

When an investor invests in the equity of another company and owns more than 50% of its voting shares, it is said to exert control over the company. The investor is known as the parent company, and the investee is then known as the subsidiarySubsidiaryA subsidiary (sub) is a business entity or corporation that is fully owned or partially controlled by another company, termed as the parent, or holding, company.  Ownership is determined by the percentage of shares held by the parent company, and that ownership stake must be at least 51%.. In such a case, investments made by the parent company are accounted for using the consolidation method.Consolidation MethodThe consolidation method is a type of investment accounting used for incorporating and reporting the financial results of majority owned investments.

The consolidation method records “investment in subsidiary” as an asset on the parent company’s balances, while the subsidiary records an equal transaction in its balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting.. The subsidiary’s assets, liabilities, and all profit and loss items are then combined periodically and reported in consolidated financial statements.

Alternatively, when an investor does not exercise full control of the investee but exerts some influence over its management, typically represented by owning 20-50% of the voting shares, the investments will be accounted for using the equity method.

The equity method records the investment as an asset, more specifically as an investment in associates or affiliates, and the investor accrues a proportionate share of the investee’s income equal to the percentage of ownership. This share of the income is known as the “equity pick-up.”  The proportionate share of dividends from the subsidiary is deducted from the investment in the affiliate’s account.

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Additional Resources

Thank you for reading CFI’s guide to the cost method of accounting for investments. CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)®DesignationsGuides to financial services designations. This section covers all the major designations in finance ranging from CPA to FMVA. These prominent designations cover careers in accounting, finance, investment banking, FP&A, treasury, IR, corporate development and skills like financial modeling, program in financial modeling and valuation. To learn more and advance your career, explore these additional CFI resources:

• Investor InfluenceInvestor InfluenceThe level of investor influence a company holds in an investment transaction determines the method of accounting for said private investment. The accounting for the investment varies with the level of control the investor possesses.
• Public SecuritiesPublic SecuritiesPublic securities, or marketable securities, are investments that are openly or easily traded in a market. The securities are either equity or debt-based.
• Treasury Stock MethodTreasury Stock MethodThe treasury stock method is a way for companies to compute the number of additional shares that can possibly be created by un-exercised,
• Treasury StockTreasury StockTreasury stock, or reacquired stock, is a portion of previously issued, outstanding shares of stock that a company repurchased from shareholders.