Last update 05/08/2019
A method of accounting for an investment, whereby the investment is recognised at cost. The investor recognises revenue from the investment only to the extent that the investor is entitled to receive distributions from accumulated surpluses of the investee arising after the date of acquisition. Entitlements due or received in excess of such surpluses are regarded as a recovery of investment, and are recognised as a reduction of the cost of the investment.
The cost method is used when making a passive, long-term investment that doesn’t result in influence over the company. The cost method should be used when the investment results in an ownership stake of less than 20%, but this isn’t a set-in-stone rule, as the influence is the more important factor.
Under the cost method, the stock purchased is recorded on a balance sheet as a non-current asset at the historical purchase price, and is not modified unless shares are sold, or additional shares are purchased. Any dividends received are recorded as income, and can be taxed as such (depending on local tax laws).
If the investee has undistributed earnings, they do not appear in any way in the records of the investor.
The alternative method of accounting for an investment is the equity method. The equity method is only used when the investor has significant influence over the investee. It is considerably easier to account for investments under the cost method than the equity method, given that the cost method only requires initial recognition and a periodic examination for impairment.
ABC International acquires a 10% interest in Purple Widgets Corporation for $ 1,000,000. In the most recent reporting period, Purple recognises $ 100,000 of net income and issues dividends of $20,000. Under the requirements of the cost method, ABC records its initial investment of $ 1,000,000 and its 10% share of the $ 20,000 in dividends. ABC does not make any other entries.
Investment valued at cost
Investment valued at cost
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