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.
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.
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:
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):