According to the Financial Accounting Standards Board (FASB), the cost method of accounting is a legitimate accounting method to account for investments. If there is no substantial influence of the investment holder over the company invested in, or if there is no readily determinable fair value, the cost method of accounting is usually the one used.
Under this method, the investment is recorded in the balance sheet at historical cost. Here is a brief look into what is the concept and usage of the cost method of accounting without getting into the nitty-gritty of its types, like full cost method, average cost method, etc.
Cost Method of Accounting for Investments
Highlighted here are the cost method of accounting for investments specifically and not the general methods of cost accounting used in the internal firm product or service costing (accounting).
- The original cost of the investment, that is the historical cost paid for the investment, when it was first bought, is the one that is recorded in the balance sheet.
- Once the balance sheet entry has been made, no further adjustments and changes are required to be made, unless the fair market value of the investment drops to such an extent that there is doubt over any kind of possible recovery. Under such a circumstance, a permanent write-off of the investment is made.
- If any dividends are declared on the investment in question, the dividends are recorded like normal dividends and the usual accounting entries are passed for the same.
- Any undistributed earnings on the investments are not recorded in the owner's balance sheet and hence have no effect on the final balance sheet, per se.
- The consolidation process under this method of accounting requires that both, the investment account and the dividend account, be eliminated completely when the parent and the subsidiary consolidate their accounts. You can use accounting software to aid with the consolidation process.
- It is important to note here that no matter which method of accounting is used (cost or equity), the consolidated financial statements will be identical for both.
If the parent company uses the cost method of accounting for investments, the consolidation worksheet entries go in the sequence.
Consolidation starts with eliminating the book value of net assets at acquisition from the parent's balance sheet. The second step is to record all excess costs incurred in or during consolidation phase. The difference between the effect of prior periods on retained earnings and current effects on the income statement and balance sheet are then amortized.
A series of elimination entries then follow, namely, dividend income, accumulated depreciation at acquisition, and other inter-company transactions.
Equity Method vs. Cost Method of Accounting for Investments
Here are a few differences between the equity accounting method for investments and the cost accounting method for investments.
- The equity method of accounting is used when there is a significant influence or control, with the investment being between 20 to 50 percent of the total stock of the firm invested in. The cost method, as mentioned earlier, is preferably used for lesser investment percentages.
- It has an advantage over equity method of accounting when there is no fair, easily determinable value for the investment.
- It is easier to calculate the return on investment and do other financial analysis of figures when equity accounting method is used. As the cost method uses working paper and not the general ledger, all figures must be tracked there first.
- It includes less paperwork than the equity method. On the other hand, being more comprehensive, the financial statements done using the equity method are more useful to the internal management for facilitating analysis.
- The best scoring point of equity method over cost method is easy self-checking feature. Consolidated financial statements should tally with certain parent figures, or the problem can be identified and corrected. The cost method has no such feature.
If you could not understand the accounting terms, look it up on the accounting terms and definitions glossary.