Cost Method

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

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.
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.

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

Online References

Suggested Books for Further Studies

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

Fundamentals of the Cost Method: Accounting Basics Quiz

### Under what circumstances is the Cost Method typically used? - [x] When a company owns less than 20% of another company's voting common stock. - [ ] When a company owns more than 50% of another company's common stock. - [ ] When a company fully controls another company. - [ ] In all cases irrespective of the investment percentage. > **Explanation:** The Cost Method is generally used when the investor owns less than 20% of the voting common stock of the investee, indicating a lack of significant influence. ### Does the Cost Method require periodic recognition of the subsidiary's income or loss? - [ ] Yes, it requires periodic recognition. - [ ] Only annual recognition is needed. - [x] No, it does not require recognition. - [ ] Quarterly recognition is mandatory. > **Explanation:** Under the Cost Method, the parent company does not recognize periodic income or losses from the subsidiary. ### What happens to the investment carrying amount if the subsidiary suffers losses under the Cost Method? - [x] It remains at its original historical cost. - [ ] It increases proportionately. - [ ] It is adjusted downwards immediately. - [ ] It depends on the market value of the subsidiary. > **Explanation:** The investment remains at its original historical cost unless there is evidence of impairment. ### How are dividends treated under the Cost Method? - [x] They are recorded as income. - [ ] They reduce the investment account balance. - [ ] They are ignored. - [ ] They are recorded as expenses. > **Explanation:** Dividends received are recorded as income in the financial statements under the Cost Method. ### When is it appropriate to use the Equity Method instead of the Cost Method? - [ ] When the investor has no control at all. - [ ] When the investor owns more than 50% of the voting stock. - [x] When the investor has significant influence, typically ownership between 20% and 50%. - [ ] When the investor owns less than 5% of the voting stock. > **Explanation:** The Equity Method is used when the investor has significant influence over the investee, typically when owning between 20% and 50%. ### What condition justifies changing from the Cost Method to another accounting method? - [ ] The investor's financial statements need simplification. - [ ] The investment's market value appreciates. - [x] Significant influence over the investee is acquired. - [ ] The investor’s ownership stake decreases. > **Explanation:** A gain in significant influence over the investee would justify switching from the Cost Method to the Equity Method. ### How is an impairment recognized under the Cost Method? - [x] The carrying amount is reduced to the fair value. - [ ] Amortized equally over several years. - [ ] Adjusted only in internal records. - [ ] Ignored unless liquidated. > **Explanation:** If there is evidence of impairment, the carrying amount is written down to its fair value. ### What term describes the ability to influence the financial and operating policies of an investee? - [x] Significant Influence - [ ] Control - [ ] Dominant Authority - [ ] Partial Ownership > **Explanation:** Significant Influence is the term that describes the ability to affect the financial and operating policies of the investee without full control. ### Which financial statements carry implications of using the Cost Method? - [x] Balance Sheet - [ ] Profit & Loss Statement - [ ] Cash Flow Statement - [ ] Statement of Retained Earnings > **Explanation:** The investment in the subsidiary is reflected at historical cost on the Balance Sheet under the Cost Method. ### When may a company use the Cost Method despite owning 30% of another company? - [x] When there is no significant influence over the investee. - [ ] When it intends to sell the investment quickly. - [ ] When the investee demands it. - [ ] When the market value of the investment is high. > **Explanation:** The Cost Method may still be applied when there is ownership between 20% and 50% but the investing company lacks significant influence.

Thank you for understanding the nuances of the Cost Method in accounting. Keep pushing the boundaries of your financial knowledge!