Definition
The cost method is an accounting approach whereby investment in a company is recorded at the original cost. This cost includes the purchase price and any other acquisition charges such as brokers’ fee. The investment remains at the original cost until the investment is sold, at which point gain or loss is recognized.
Key Takeaways
- The Cost Method is a financial strategy for recording the purchase of a significant stake in a company, typically utilized when an investor does not have the ability to exert significant influence over the company’s operations.
- In the Cost Method, rather than recording dividend revenue when it’s declared, the investment is recorded at cost; changes to the market value of the investment do not affect the accounting records or financial statements of the investor’s business.
- Under the Cost Method, returns on investment are only recognized when cash dividends are received from the investee. This method ensures only realized gains are recorded, making it conservative from an investor’s perspective.
Importance
The Cost Method is a vital finance term as it refers to an accounting methodology that involves recording investments at their original cost.
It plays a significant role in the valuation of assets or inventory and maintaining a clear financial record.
It emphasizes keeping records at the purchase price rather than current market price, ensuring a conservative approach by recognizing gains only when they are realized.
Overall, it helps in maintaining systematic and accurate financial statements, providing crucial information to investors and stakeholders about the company’s financial position and performance.
Also, it aids in efficient decision making facilitating strategic planning for the future.
Explanation
The primary purpose of the cost method is to track and record investments that a company makes in other firms. This accounting technique determines the value and profitability of an investment, based on the initial cost at which it was acquired.
Under the cost method, the investment is recorded on the balance sheet at its acquisition cost, and any later changes in the market price do not affect this valuation. This serves to provide an accurate and consistent representation of the investment’s original purchase value over time, regardless of fluctuating market conditions.
The cost method has practical applications in instances where a business has obtained a minority stake in another company, often less than 20%. This method serves to keep a straightforward record of the cash outflow related to the investment, without accounting for the investee’s financial performance. Therefore, this method is ideal for one-off or non-strategic investments where the investing company does not exercise significant influence over the investee.
Any returns, like dividends received from the investment, are recognized as a separate gains in the investor’s income statement, rather than adjusting the initial cost of the investment.
Examples of Cost Method
Sure, here are three real-world examples of the cost method in finance:Investment in Stocks: Imagine an investor buys 500 shares of company XYZ, each unit priced at $
So, the cost he incurred or paid is $5,In the cost method, this cost of $5,000 will represent the value of the investment in the investor’s financial statements. Even if the value of company XYZ’s shares increases or decreases, it won’t have an impact on the investor’s balance sheets as long as the cost method is used.
Real Estate: Suppose a company buys a piece of land for its new factory at a price of $2 million. The value of the land continues to increase but because the company uses the cost method for its financial reporting, the land will always be reported at its acquisition cost i.e., $2 million.Furniture Business: A furniture retailer buys a table from a manufacturer for $
The retailer will record the table in its books as an inventory asset of $The cost remains at $100 regardless of whether the market price of the table fluctuates or not. This is a typical example of the cost method.
FAQs on Cost Method
1. What is the Cost Method?
The Cost Method is a financial accounting technique that records the expenses and revenues for an investment in a subsidiary at the price paid for the shares. It is frequently used when the parent company owns less than 20% of another company’s shares.
2. When is the Cost Method appropriate to use?
This method is generally considered appropriate when the parent company owns a small stake in a company and does not have significant influence over the company’s operational and financial policies.
3. How is the Cost Method different from the Equity Method?
In the Equity Method, the investment is initially recorded at cost, and this value is adjusted based on the investor’s share of the profit or loss of the investee after the date of acquisition. However, under the Cost Method, the investment remains at the initial cost and changes only if there’s a change in the number of shares owned.
4. What happens when a dividend is received under the Cost Method?
Under the Cost Method, dividends received are considered as a return on investment and are recorded as income. This could lead to a double-counting of income if the individual also records an increase in the value of the investment.
5. Are there any drawbacks to using the Cost Method?
While the Cost Method does have its advantages, there are potential drawbacks as well. One chief criticism is that it doesn’t provide a realistic estimate of the subsidiary’s value if its market value is significantly more than its cost.
Related Entrepreneurship Terms
- Investment-Related Accounting
- Asset Valuation
- Inventory Costing
- Capitalization of Assets
- Noncontrolling Interests (Minority Interest)
Sources for More Information
- Investopedia: A trusted online resource for finance and investment terms and education.
- AccountingTools: A site specializing in accounting and finance understanding, including cost method.
- Corporate Finance Institute: A professional institute with courses and articles related to finance, including cost method.
- The Balance: Provides comprehensive, understandable explanations of finance and money management topics like cost method.
