A method of accounting for investments
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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 thesale. 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 Securities | 1,000,000 | |
| Cr. | Cash | 1,000,000 | |
At the end of the year, Traderson receives 10% of the $100,000 dividends (as Traderson holds 10% of Bullseyes shares)
| Dr. | Cash | 10,000 | |
| Cr. | Dividend Revenue | 10,000 | |
What are the Other Accounting Methods?
When a company 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 investing company is known as the parent company, and the investee is then known as the subsidiary. In such a case, the parent company uses the consolidation method for accounting purposes.
The consolidation method records 100% of the subsidiary’s assets and liabilities on the parent company’s balance sheet, even though the parent may not own 100% of the subsidiary’s equity. The parent income statement will also include 100% of the subsidiary’s revenue and expenses. If the parent does not own 100% of the subsidiary, then the parent will allocate to the noncontrolling interest the percentage of the subsidiary’s net income that the parent does NOT own.
As an example, assume Company A owns 75% of Company B: this creates a 25% noncontrolling interest in Company B. Company A will fully consolidate its financials with Company B. In other words, Company A will claim 100% of Company B’s revenues and expenses and assets and liabilities. However, Company A will allocate 25% of Company B’s net income to noncontrolling interest. Noncontrolling interest is also shown in Shareholder’s Equity on the parent’s balance sheet.
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 theFinancial Modeling & Valuation Analyst (FMVA)® program in financial modeling and valuation. To learn more and advance your career, explore these additional CFI resources:
