Cost Method

The Cost Method is an accounting technique used by a parent company for investments in subsidiary companies, particularly when ownership is less than 20% of the outstanding voting common stock.
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Definition

The Cost Method is an accounting approach used by a parent company to record investments in subsidiary companies. Under this method, the investment in the subsidiary is maintained on the books at its original cost, and periodic recognition of the parent company’s share of the subsidiary’s income or loss is not required. This method is generally employed when the parent company owns less than 20% of the subsidiary’s outstanding voting common stock. It can also be used if the ownership ranges between 20% and 50% but effective control (significant influence) is absent.

Examples

  1. Minority Investment:

    • Scenario: Company A invests $500,000 to acquire an 18% stake in Company B.
    • Accounting Treatment: Company A uses the Cost Method to record this investment, keeping it at $500,000 on the balance sheet without adjusting for Company B’s profits or losses.

  2. Non-Controlling Interest:

    • Scenario: Company X owns 25% of Company Y but does not have significant influence over Company Y’s operations.
    • Accounting Treatment: Company X can opt to use the Cost Method if it cannot exercise significant influence, maintaining the investment at its original purchase cost.

Frequently Asked Questions (FAQs)

Q1: When should a company use the Cost Method?

A1: The Cost Method is used when a company holds less than 20% of another company’s voting common stock. It may also be used for investments between 20% and 50% when there is no significant influence over the investee.

Q2: How does the Cost Method differ from the Equity Method?

A2: Under the Cost Method, the investment is recorded at its historical cost, and periodic income or losses from the subsidiary are not recognized in the investor’s income. In contrast, the Equity Method requires the investor to recognize their share of the investee’s income or losses.

Q3: Can the investment value under the Cost Method change?

A3: The value of the investment under the Cost Method remains at historical cost unless there is evidence of impairment, which would necessitate a write-down to the fair value.

Q4: How are dividends treated under the Cost Method?

A4: Dividends received from the investment are recorded as income in the financial statements of the investor.

Q5: How does a lack of effective control affect method selection?

A5: Lack of effective control may prompt the use of the Cost Method when ownership lies between 20% and 50%, due to the absence of significant influence over the subsidiary’s policies and decisions.

  1. Equity Method:
    • An accounting technique used when the investor has significant influence over the investee, typically between 20% and 50% ownership.
  2. Impairment:
    • A reduction in the carrying amount of an asset to its recoverable amount when it is less than the book value.
  3. Significant Influence:
    • The ability to participate in the financial and operating policy decisions of the investee but not control them.

Online References

  1. Investopedia: Cost Method
  2. AccountingTools: Cost Method Definition

Suggested Books for Further Studies

  1. “Financial Accounting: An Introduction to Concepts, Methods, and Uses” by Roman L. Weil, Katherine Schipper, and Jennifer Francis.
  2. “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
  3. “Accounting for Investments, Equities, Futures and Options” by R. Venkata Subramani.

Fundamentals of the Cost Method: Accounting Basics Quiz

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