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Definition
The term cost method refers to an accounting approach used when an investor has passive interest in another company. In practice, the cost method is used when an investor (company) does not have a controlling interest or is unable to exert significant influence over the investee, but has made a long-term investment in that company.
This accounting method requires companies to carry and report the investment at cost until disposed of, or when it's clear that historical cost is no longer justified.
Explanation
Unlike marketable securities, which are short term investments, an ownership interest in another company represents a long-term investment. Generally, ownership falls into three categories: controlling interest, significant influence, and passive interest. When a company holds less than 20% of the investee's voting stock, or is unable to exert significant influence over the decisions made by the investee, the long-term investment is categorized as passive interest.
When a company has passive interest, or is unable to exert significant influence over another, it is required to use the cost method of accounting. This method requires the investor (company) to record the initial investment at cost on the balance sheet, and continue to carry that investment at cost until the shares of stock are partially or entirely sold. Adjustments to the carrying value should also be made if it's clear that original cost is no longer a justifiable value. For example, the investee might declare a liquidating dividend.
The cost method also applies to passive investments in the equity securities of closely held companies that do not have actively traded stock, since these nonmarketable securities do not have a clearly determinable value until sold.
Example
On January 1, Company A acquired 100,000 shares of Company XYZ's common stock for $20.00 per share. This acquisition represented 4.0% of the voting stock of Company XYZ. The journal entry to record the initial investment in Company XYZ would be as follows:
Debit | Credit | |
Long-Term Investment in Company XYZ | $2,000,000 | |
Cash | $2,000,000 |
At yearend, Company XYZ reported net income of $4,000,000 and paid a dividend of $0.50 per share. Under the cost method, Company A does not make an adjustment to the carrying value of Company XYZ. The only journal entry required under this method is one that records the payment of the dividend ($0.50 per share x 100,000, or $50,000):
Debit | Credit | |
Cash | $50,000 | |
Revenue from Investment | $50,000 |
Related Terms
The term marketable securities, held-to-maturity is used to describe investments in debt securities that a company intends, and is able, to hold for their full term.
Moneyzine EditorFebruary 8th, 2024
The term marketable securities, available-for-sale is used to describe investments in debt and equity securities that a company does not intend to trade for profit or hold until maturity. In practice, marketable securities that are "available-for-sale" are those that are not classified as either "trading" or "held-to-maturity." Marketable securities are a subset of short-term investments; as such, they appear on the company's balance sheet and are classified as a current asset.Moneyzine EditorSeptember 20th, 2023
The term marketable securities, trading is used to describe investments in debt and equity securities that a company intends to buy and sell for profit. Marketable securities, including common stocks and bonds purchased for the purpose of trading, are typically held for a period of less than three months.Moneyzine EditorFebruary 8th, 2024- The financial accounting term ownership interest is used to describe the degree to which one company has acquired common stock in another. Ownership interest generally falls into three categories: controlling, significant influence, and passive.Moneyzine EditorSeptember 20th, 2023
The term equity method refers to an accounting approach used when an investor has controlling interest or significant influence over another company. In practice, the equity method is used by companies that have a significant economic interest in another. This accounting method requires companies to periodically adjust their net assets as the value of this economic interest changes over time.Moneyzine EditorJanuary 17th, 2024- The term revenue from investments in stock refers to an approach companies can use to determine when to record income generated by their investments in common stock. There are several methods a company can use to account for these long and short-term investments. Each method has a slightly different approach to account for a stock's change in value or dividends received.Moneyzine EditorSeptember 21st, 2023
