What is the Cost Method?
The
cost method is an accounting technique used to record investments in other companies. Under this method, the investment is recorded at its original cost, and adjustments are only made for dividends received and potential impairments. This approach is typically used when the investor does not have significant influence over the investee, usually when owning less than 20% of the company's outstanding shares.
How is the Cost Method Applied?
When an investment is acquired, it is recorded on the balance sheet at its purchase price. Subsequent to the acquisition, the carrying amount of the investment is adjusted only for
dividends received that are declared out of post-acquisition earnings. If the dividends received exceed the investor's share of earnings, the excess is treated as a return of capital, reducing the carrying amount of the investment. No adjustments are made for the investor’s share of the investee’s profits or losses.
Advantages of the Cost Method
The cost method offers several advantages: Simplicity: The calculations and accounting records are straightforward, making it easier to implement and maintain.
Consistency: Since investments are recorded at cost, there is less volatility in earnings and asset values.
Tax Benefits: Under certain jurisdictions, unrealized gains are not taxed until the investment is sold, potentially deferring tax liabilities.
Disadvantages of the Cost Method
Despite its advantages, the cost method also has some drawbacks: Irrelevance of Market Fluctuations: It does not reflect current market values, potentially leading to undervaluation or overvaluation of assets.
Lack of Influence Recognition: It fails to recognize the investor's influence on the investee’s operations, which might be significant even with a small percentage of ownership.
Impairment Risk: It requires periodic reviews for impairment, which can be subjective and complex.
When the investor holds a minority interest, typically less than 20% of the voting stock.
When the investor does not have significant influence over the investee's management or policies.
When the investment is in non-marketable securities, making fair value assessments challenging.
Equity Method: Used when the investor has significant influence (typically 20-50% ownership). The investment is initially recorded at cost, but subsequently adjusted for the investor's share of the investee's profits or losses.
Fair Value Method: Used when investments are held for trading or available for sale. The investment is recorded at fair value, with changes in fair value recognized in earnings (for trading securities) or other comprehensive income (for available-for-sale securities).
Real-World Application of the Cost Method
Many businesses use the cost method for their investments in
subsidiaries,
joint ventures, or
affiliates where they do not exert significant influence. For instance, a company might use the cost method to account for its investment in a start-up where it holds a minority stake and has no role in decision-making.
Conclusion
The cost method is a straightforward accounting approach that provides simplicity and consistency in financial reporting. However, businesses must evaluate whether this method appropriately reflects their investment's economic realities, especially when compared to the equity and fair value methods. Understanding the nuances of each method allows businesses to make informed decisions about which approach best suits their financial and operational objectives.