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Cost Method

A method of accounting for investments

What is the Cost Method?

The cost method of accounting is used for recording certain investments 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 statement. 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 income 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 security it deems, but it will generally classify it as an asset.

Dr.Trading Securities1,000,000
Cr.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.Cash10,000
Cr.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 subsidiary. In such a case, investments made by the parent company are accounted for using the consolidation method.

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 sheet. 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)® program in financial modeling and valuation. To learn more and advance your career, explore these additional CFI resources:

  • Investor Influence
  • Public Securities
  • Treasury Stock Method
  • Treasury Stock

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