The cost method is an accounting standard used primarily to account for investments in other entities when the investor holds a passive stake and does not exert significant influence over the investee's operations. This approach falls under the broader category of investment accounting. Under the cost method, the investment is initially recorded on the balance sheet at its original purchase price or historical cost and generally remains at this value unless there is an indication of impairment. Dividends received from the investee are recognized as revenue on the investor's income statement.
History and Origin
The foundational concept behind the cost method, historical cost accounting, has been a cornerstone of financial reporting for many years, valuing assets and liabilities at their original acquisition cost. Early accounting standards, such as those developed by the American Institute of Certified Public Accountants (AICPA) in the early 20th century, provided a framework for consistent and accurate financial reporting, heavily relying on the historical cost principle.26 The cost method itself evolved as a straightforward approach for recognizing investments where the investing entity has minimal influence over the investee. For instance, the Financial Accounting Standards Board (FASB) provides guidance under Accounting Standards Codification (ASC) 325-20, which outlines the application of the cost method for certain investments in noncontrolled corporations.25 Similarly, under International Financial Reporting Standards (IFRS), specifically IAS 28, while primarily outlining the equity method, it notes that initial recognition of an investment in an associate or joint venture is at cost.24
Key Takeaways
- The cost method records an investment at its initial purchase price on the balance sheet.
- It is typically used for investments where the investor holds less than 20% of the investee's voting shares and has no significant influence.
- Dividends received from the investee are recognized as income on the investor's income statement, affecting profit.
- The investment's carrying value is generally not adjusted for changes in the investee's underlying net assets or market value, unless there is an impairment.
- The cost method is simpler to apply compared to other accounting methods due to fewer required adjustments.
Interpreting the Cost method
When an investment is accounted for using the cost method, the recorded value on the investor's balance sheet remains constant at its original purchase price. This means that fluctuations in the investee's market value or its undistributed earnings do not directly impact the carrying amount of the investment on the investor's financial statements. Instead, the investor recognizes income only when it receives a dividend from the investee. For example, if an investor purchases shares for $100,000 using the cost method, and the market value of those shares increases to $150,000, the investment would still appear as $100,000 on the investor's balance sheet until it is sold or impaired. This approach emphasizes the historical transaction rather than ongoing market valuation or changes in underlying equity.
Hypothetical Example
Assume Company A purchases 10% of Company B's common stock for $50,000 on January 1. Company A considers this a passive investment with no significant influence, thus applying the cost method.
Initial Purchase (January 1):
Company A records the investment as an asset on its balance sheet:
| Account | Debit | Credit |
|---|---|---|
| Investment in Co. B | $50,000 | |
| Cash | $50,000 | |
| To record the purchase of 10% of Company B's stock. |
Dividend Received (December 31):
Later that year, Company B announces and pays a total dividend of $20,000. Company A, owning 10%, receives $2,000 ($20,000 * 10%). Company A records this as dividend income on its income statement:
| Account | Debit | Credit |
|---|---|---|
| Cash | $2,000 | |
| Dividend Income | $2,000 | |
| To record dividend income from Company B. |
Even if Company B's underlying net assets or stock price increased significantly during the year, Company A's "Investment in Co. B" account would remain at $50,000 on its balance sheet under the cost method.
Practical Applications
The cost method is applied in various scenarios within investment accounting, particularly when an investor holds a small, non-controlling interest in another entity. It is commonly used for equity investments where the investor owns less than 20% of the investee's voting shares and does not have the ability to significantly influence the investee's financial and operating policies. This method is appropriate when neither the consolidation method (for controlling interests) nor the equity method (for significant influence) is applicable.
For instance, investments in non-marketable equity securities, which lack readily determinable fair value, are often accounted for using the cost method.23 Under U.S. Generally Accepted Accounting Principles (GAAP), specifically ASC 325-20, the cost method is typically followed for most investments in noncontrolled corporations and, to a lesser extent, in certain corporate joint ventures or unconsolidated subsidiaries.22 Dividends received from these investments are recorded as income by the investor.21 According to PwC, if an investor concludes that consolidation or the equity method is not required, the cost method should generally be used, unless the investment falls under other specific fair value accounting guidance.20
Limitations and Criticisms
While the cost method offers simplicity, it faces several criticisms for its limitations in reflecting the true economic reality of an investment. A primary drawback is that it does not adjust for changes in the fair value of the investment over time, nor does it reflect the investee's undistributed earnings or losses.19 This adherence to historical cost can result in the investment being carried on the balance sheet at a value significantly different from its current market value, potentially leading to inaccurate financial statements that may mislead investors.18 For example, if an investee experiences substantial profit growth that is not distributed as dividends, the investor's financial records using the cost method would not reflect this increased underlying value.
Furthermore, the cost method does not account for the effects of inflation, which can distort the reported value of older assets over time.17 Critics argue that such an accounting approach can hinder timely and relevant financial reporting, particularly in dynamic economic environments where asset values fluctuate considerably.16 Gains are only recognized when dividends are issued or when the investment is sold, meaning unrealized gains from appreciating asset values are not captured.15
Cost method vs. Equity method
The primary distinction between the cost method and the equity method lies in the degree of influence an investor has over the investee and how that influence dictates the accounting treatment of the investment.
| Feature | Cost Method | Equity Method |
|---|---|---|
| Investor Influence | Little or no significant influence (typically < 20% ownership)14 | Significant influence (typically 20% to 50% ownership)12, 13 |
| Initial Recognition | Recorded at historical cost.11 | Recorded at historical cost.10 |
| Subsequent Adjustments | Value remains at historical cost; only adjusted for impairment.9 | Investment account adjusted for investor's share of investee's net income/losses and reduced by dividends received.8 |
| Income Recognition | Only recognizes dividend income when received.7 | Recognizes a proportionate share of the investee's net income (or loss) as it is earned.6 |
| Balance Sheet Reflection | Does not reflect changes in investee's underlying net assets or market value.5 | Reflects changes in the investee's underlying net assets, providing a more current representation.4 |
| Typical Use | Passive investments, non-marketable securities.3 | Investments in associates and joint ventures.2 |
Confusion often arises because both methods initially record the investment at cost. However, the subsequent accounting treatment diverges significantly based on the investor's ability to influence the investee's operations and financial policies. The cost method maintains the initial cost, while the equity method continually updates the investment's carrying value to reflect the investor's share of the investee's performance.
FAQs
When is the cost method typically used?
The cost method is generally used when an investor owns a small percentage (typically less than 20%) of another company's voting stock and does not have the ability to significantly influence the investee's operating or financial decisions. It's also applied to non-marketable equity securities where a reliable fair value cannot be determined.
How are dividends treated under the cost method?
Under the cost method, any dividend received from the investee is recognized as dividend income on the investor's income statement. These dividends are recorded as income when they are declared or received, and they do not reduce the carrying value of the investment on the balance sheet.
Does the cost method reflect the current market value of an investment?
No, the cost method does not reflect the current fair value of an investment. The investment is recorded at its original purchase price and remains at that value unless there is evidence of a permanent decline in its value (impairment), or the investment is sold. This is a significant limitation compared to other accounting methods that incorporate market value adjustments.
What are the main disadvantages of using the cost method?
The primary disadvantages of the cost method include its failure to reflect current market conditions or changes in the investee's underlying value, potentially leading to an understatement or overstatement of the investment's true worth on the balance sheet. It also doesn't account for the impact of inflation, and any profit earned by the investee is not recognized by the investor until distributed as a dividend.
Is the cost method allowed under GAAP and IFRS?
Yes, the cost method is allowed under both U.S. GAAP and IFRS for certain types of investments. Under U.S. GAAP, ASC 325-20 provides guidance for cost method investments. Under IFRS, while the equity method is typically prescribed for associates, initial recognition of an investment is still at cost, and for purely passive investments without significant influence, entities would generally apply IFRS 9 Financial Instruments, which may result in a fair value measurement or, for certain unquoted equity instruments, may permit cost less impairment.1