What is the cost method of accounting?

The Cost Method: Accounting for Minor Investments

In the world of investing, accurately tracking the value and impact of your holdings is crucial. Different levels of investment ownership require different accounting approaches. One such method, particularly relevant for investors with relatively small stakes, is the cost method.

The cost method is a straightforward accounting technique used primarily when an investor holds a minor investment in another company, typically less than 20% of the investee’s outstanding shares. It’s a simple approach that focuses on the initial cost of the investment, making it ideal when the investor lacks significant influence over the investee’s operations.

How Does it Work?

Under the cost method, the investment is recorded on the investor’s balance sheet at its original purchase price. This price includes not only the cost of the shares but also any incidental costs associated with acquiring the investment, such as brokerage fees.

The beauty of the cost method lies in its simplicity. After the initial recording, the investment generally remains at its original cost, regardless of fluctuations in the investee company’s market value or profitability. This means that the investor’s balance sheet will not reflect the ups and downs of the investee’s stock price.

What Happens to Dividends and Income?

While the investment itself remains at cost, any dividends received from the investee are recognized as income on the investor’s income statement. This is the primary way the investor recognizes financial benefits from the investment under the cost method.

Impairment is Key

The only time the value of the investment is adjusted under the cost method is when there is a permanent impairment in the value of the investment. Impairment occurs when there is a significant and sustained decline in the investee’s fair value below its cost, and it’s deemed unlikely that the investment will recover.

For example, if the investee experiences a major business disruption, files for bankruptcy, or suffers a significant decline in its industry, the investor may need to recognize an impairment loss. This loss is recorded on the income statement, and the investment on the balance sheet is written down to its fair value.

Why Choose the Cost Method?

The cost method is preferred when the investor has a limited stake and little to no influence over the investee. It’s a practical choice because:

• Simplicity: It’s easy to understand and implement, requiring minimal ongoing adjustments.
• Efficiency: It reduces the administrative burden of constantly tracking and revaluing the investment.
• Appropriateness: It accurately reflects the investor’s limited role in the investee’s operations.

Alternatives to the Cost Method

It’s important to note that the cost method is not the only way to account for investments. Other methods, such as the equity method and consolidation, are used when the investor has more significant influence or control over the investee. These methods are more complex and require a deeper understanding of the investee’s financial performance.

In conclusion, the cost method provides a straightforward and efficient way for investors with minor stakes in other companies to account for their investments. By focusing on the initial purchase price and recognizing dividends as income, it offers a practical approach that reflects the investor’s limited influence and simplifies the accounting process. While the cost method is not suitable for all investment scenarios, it remains a valuable tool in the accountant’s arsenal, particularly when dealing with small, passive investments.