Cost method

Definition

The cost method is an accounting approach used to record investments in securities where the investor recognizes the investment at its purchase price and does not adjust the carrying value for changes in market value. This method is primarily used when the investor does not have significant influence over the investee, typically indicating ownership of less than 20% of the voting stock. The cost method emphasizes the initial transaction cost and recognizes income only when dividends are received or the investment is sold.

5 Must Know Facts For Your Next Test

1. Under the cost method, investments are recorded on the balance sheet at their historical cost, meaning no adjustments are made for market fluctuations unless there is an impairment.
2. Investors using the cost method recognize income only when they receive dividends from the investee, which is treated as income in the period it is declared.
3. This method does not allow for unrealized gains or losses to be reported on the financial statements, leading to potential discrepancies between book value and market value.
4. The cost method is simpler to apply compared to other methods, such as the equity method, making it suitable for passive investments where control is not exerted.
5. If an investor later gains significant influence over the investee, they may need to switch from the cost method to the equity method for accounting purposes.

Review Questions

• How does the cost method impact the financial statements of an investor who has purchased shares but does not have significant influence over the investee?
  • Using the cost method, the investor will record their investment at its purchase price and will not adjust this amount for market changes. This means that on the balance sheet, the investment remains static until it is sold or dividends are received. The income statement will only reflect income from dividends when declared, not from any increase in value of the shares held.
• Compare and contrast the cost method with the equity method in terms of how each reflects an investor's relationship with an investee.
  • The cost method records investments at historical purchase price without recognizing market value changes and reports income solely from dividends. In contrast, the equity method recognizes an investor's share of the investee's net income or loss, adjusting the carrying value of the investment accordingly. While the cost method applies to passive investments typically below 20% ownership, the equity method applies when an investor has significant influence, generally defined as owning 20% to 50% of voting stock.
• Evaluate how transitioning from the cost method to another accounting method might affect an investor's financial reporting and decision-making processes.
  • Transitioning from the cost method to a more complex accounting approach like the equity method can significantly impact financial reporting. The investor would start reflecting their share of profits and losses from the investee on their income statement, which could provide a clearer picture of financial performance. This shift requires more detailed analysis and monitoring of investee operations, influencing decision-making around future investments and divestitures based on performance insights rather than just dividend returns.

Related terms

Dividends: Payments made by a corporation to its shareholders, typically in cash or additional shares, representing a portion of the company's earnings.

Investment: An asset or item acquired with the goal of generating income or appreciation over time, commonly seen in stocks, bonds, and real estate.

Significant Influence: The power to participate in financial and operating policy decisions of an investee but without control, usually indicated by ownership between 20% and 50%.