Cost Method

A method of accounting for investments

What is the cost method?

The cost method is a type of investment accounting used in investments. This method is used when the investor exerts little or no influence over an investee. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, the term “investment” is simply used.

 

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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 immediately recognized on the income statement. This 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 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 2,000,000. At the end of the year, Bullseye announces it will be paying out a dividend of 50,000 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 50,000 dividends (as Traderson holds 10% of Bullseyes shares)

Dr.Cash10,000
Cr.Dividend Revenue10,000

 

What are the other accounting methods?

When an investor exercises full control of the company it invests in, the investing company may be known as a parent company to the investee. The latter is then known as the subsidiary. In such a case, investments made by the parent company in the subsidiary are accounted for using the consolidation method.

The consolidation method records “investment in subsidiary” as an asset on the parent company’s balances, while recording an equal transaction in the equity side of the subsidiary’s balance sheet. The subsidiary’s assets, liabilities and all profit and loss items are reported in the consolidated financial statements.

Alternatively, when an investor does not exercise full control of the investee, but possesses some influence over its management, the investor possesses a minority active interest in the investee. In such a case, investments will be accounted for using the equity method.

The equity method records the investment as an asset, more specifically as 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”.

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