Cost Method
An accounting technique for recording companies’ investments on their financial statements
What is the Cost Method?
The Cost Method is an accounting technique used for recording companies’ investments accurately on their financial statements. In this traditional method, the investment acts as the original cost on the balance sheet. It is a relatively flexible method and can be used as per the need of a particular business.
It is mainly used when a company invests in other firms whose investment does not allow it to take control of the investees’ firms or influence their decision-making.
This depends on the degree of ownership an investing firm acquires in its target or investee. Usually, when the investment does not exceed 20% of the overall value of the investee’s voting stocks, the investor cannot take control of the firm as they will have little power in the election of the board of directors.
This will usually retain them from occupying a seat on the board that mainly hires the management team of a corporation and influence their decision-making.
Key Takeaways
- The Cost Method is an accounting approach used to accurately record a company's investments on its financial statements.
- The method involves recording the initial investment in the balance sheet as a marketable security at purchase price. Dividends from the investee are recognized as income on the income statement.
- The investment's value remains unchanged on financial statements until it is sold. Fluctuations in the investee's value do not impact the recorded value of the investment.
- The method's applicability depends on the degree of ownership; usually, it's used when the investment is less than 20% of the investee's overall value, limiting the investor's control over the investee.
How does the cost method work?
The cost method works by recording the initial value of the investment in the balance sheet under the assets section (the balance sheet is an accounting statement that lists a company's assets, liabilities, and shareholders’ equity.)
The investment is recorded as a marketable security, which is an investment of a company in another company at the price of the purchase.
Whenever the investee issues dividends, the investor should record them as an income in the income statement (the income statement is the financial statement that lists the different revenues streams and subtracts from them the cost drivers to lead to the net profit or loss of a firm)
The value of the investment is never updated on the financial statements of the investee till they decide to sell it. If so, they record the resulting cash from selling the securities, remove them from the balance sheet, and record any resulting gain or loss from selling them.
Thus using the cost method, firms report the investment at the initial price, and they never update it regardless of the fluctuations in the value of the investment. Also, they report dividends issued by the investees as dividends income on their balance sheets.
cost method Example
Let’s say you are the CEO of OrganiCo and decide with your team to invest in GreenCo. You purchase stocks that are valued at $100,000.
However, GreenCo is valued at one million dollars. Thus, your investment accounts for only 10% of GreenCo’s value, so you have no control over the firm and cannot influence its decision-making.
This purchase will be recorded by adding the investment to OrganiCo’s noncurrent assets at the initial value of $100,000 under marketable securities and subtracting the cash used to invest:
| Db. Marketable Securities | $100,000.00 |
| Cr. Cash | $100,000.00 |
Now, let’s say GreenCo issued dividends for OrganiCo that account for $10,000. These are going to be considered dividends income on Organico’s income statement, and cash will be debited on its balance sheet:
| Db. Cash | $100,000.00 |
| Cr. Dividends Income | $100,000.00 |
Moving to the last case scenario. After two years, OrganiCo wants to sell its stake in GreenCo. However, GreenCo’s value has decreased by 20% throughout this period.
Thus, OrganiCo will record the cash it collects from the sale operation and the loss that was generated in the following matter:
| Db. Cash | $80,000.00 |
| Db. Loss on securities sale | $20,000.00 |
| Cr. Marketable securities | $100,000.00 |
Cost Method Advantages and disadvantages
Like all accounting methods, the cost method has some advantages and disadvantages.
The main advantages of the cost method have to do less work, record fewer entries, and separate dividends records:
1. Less Paperwork: This method requires less paperwork compared to other accounting methods.
2. Fewer entries: This method requires fewer entries to record securities since securities are only recorded twice: when purchased and sold.
3. Separate dividends records: Dividends are recorded separately on the income statement.
The main disadvantages of the cost method are that it does not reflect the stock’s performance, account for gains, and adjust for inflation:
1. Unfair reflections on stock’s performance: The fluctuations in the values of securities are not reflected in the financial records since only two values of the stocks are recorded.
2. Gains: Gains are not recorded unless the company issues dividends. So even if the value of the stock doubled with the company not issuing dividends, no gains would be accounted for in the income statement.
3. Inflation: The cost method does not consider inflation. The value of the currency is assumed to be stable throughout the period.
Other Accounting Methods
A famous method alternatively to the Cost Method is the Equity Method. Firms decide on either technique depending on their investments’ volumes.
It is used when the investment allows the investor company to take control and influence the decision-making of the investee’s firm. This implies that the investment accounts for 20% to 50% or more of the investee’s voting stocks’ value.
The equity method records the initial investment under marketable securities on the balance sheet, and is updated periodically. The adjustments in the value of the investment are mainly based on the investor’s stake in profits, losses, or dividends.
The main aim of this technique is to increase/decrease the value of the investment according to the changes in the operational value of the investee.
The investor’s portion of profits incurred by the investee’s firm is recorded as a gain in the income statement. The value of the investment in the investor’s balance sheet increases by the same amount as their stake in profits.
As profits increase, the value of the investment and dividends decrease, then the main change is the change in the retained earnings of the investee’s firm. However, when the investee’s firm incurs losses, the investor records a loss on their income statement and a decrease in the value of the investment on the balance sheet by the same amount.
On the other hand, when dividends are issued to shareholders, the investor’s company increases their cash by the number of their collected dividends and decreases the value of the investment by the same amount.
Some other accounting methods widely used is the Fair Value Method and the Consolidation Method.
Conclusion
To sum up, briefly, the cost method is used to record a company’s investments in other companies when its investment is minor and does not allow it to take control or influence the decision-making of the investee's firm.
On the other hand, the equity method is the accounting technique used to record a company’s investment in other companies when the investment allows it to influence the decision-making and operations of the investee’s firm.
The investment is kept on the balance sheet at its initial acquisition cost rather than its fair market value, making it one of the more conservative techniques for accounting investments undertaken. When an investor's share in an investment is 20% or less, the cost method is typically used.
In the cost approach, a one-line entry is made after completing the transaction. Only when a reduction in fair value is recognized after that is the recorded value corrected.
However, the cost approach permits value adjustment after the initial transaction has been recorded unless the fair value of the investment declines. It does not, therefore, record fair fluctuation on the asset.
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