Definition: The cost method is an accounting technique used to record the investment in equity securities that do not provide significant influence over the investee’s operating and financial policies. It is one of the several methods employed by businesses to account for their investments in other entities.
Explanation: When an entity acquires a financial interest in another entity, it needs to determine the appropriate accounting method to recognize the investment. The cost method, also known as the historical cost method, is commonly used for investments where the investor does not have significant influence over the investee’s operations. Under this method, the investment is initially recorded at cost and subsequently adjusted for any dividends or changes in the investee’s equity.
In the cost method, the investor recognizes the initial investment as an asset on its balance sheet. However, unlike other methods such as the equity method, the investor does not include its proportionate share of the investee’s profits or losses in its income statement. Instead, any dividends received from the investee are typically recognized as income when received. Additionally, changes in the investee’s equity, such as stock splits or stock dividends, are adjusted accordingly.
The cost method is generally applicable to situations where the investor’s ownership stake is less than 20% and does not provide significant influence over the investee’s decision-making processes. It is typically used for passive investments, where the investor does not have control or the ability to exert influence over the investee’s financial and operating policies. Examples of entities accounted for using the cost method include small ownership interests in listed companies or investments in venture capital start-ups.
The use of the cost method provides simplicity and ease of accounting. It allows investors to avoid complex calculations related to the recognition of the investee’s revenues, expenses, and other comprehensive income. However, it may not reflect the economic substance of the investment accurately, especially when the investor has the ability to exercise significant influence over the investee.
When using the cost method, it is essential to evaluate the investment for impairment regularly. If there is an indication that the value of the investment has declined below its carrying amount, the investor needs to recognize an impairment loss in its financial statements. Impairments are typically measured by comparing the fair value of the investment with its carrying amount.
In summary, the cost method is an accounting technique used to record investments where the investor does not have significant influence over the investee’s operations. It allows for a straightforward recognition of the investment at cost and subsequent adjustments for dividends and changes in the investee’s equity. While it provides simplicity, it may not reflect the investment’s economic substance accurately in certain cases. Proper evaluation and assessment of impairment are crucial when accounting for investments using the cost method.
