Business Courses/Financial Accounting: Homework Help ResourceCourse
- AuthorDavid Kuot
David Kuot has taught Business in Capella University for over 2 years. They have a Doctor of Philosophy-PhD, candidate, Business management strategy &Innovation from Capella University. They also have HTML and Latex certifications.
View bio - InstructorJames Walsh
M.B.A. University of Pittsburgh. Corporate Manager and veteran Business and Economics teacher at a number of community colleges.
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Learn about the cost method of accounting. Discover how cost method investments are recorded, and study examples of investment accounting journal entries.Updated: 11/21/2023
Table of Contents
- What is the Cost Method of Accounting?
- Cost of Investments in a Balance Sheet
- Pros and Cons of the Cost Method of Investments
- Examples of Investment Accounting Journal Entries
- Lesson Summary
Frequently Asked Questions
Are the cost method and the fair value method the same?
The cost method differs from the fair value method in that it records investments' initial/purchase value. In contrast, the fair value method records the current value of investment available in the market. The cost method adjusts only dividends and profits from an investment, while the fair value method frequently adjusts investment value according to market price changes.
How does the cost method work?
The cost method records transaction investments when the investor owns less than 20% shares. The technique also works by testing any impairments, gains, and losses on the investment which may affect the income.
What is the difference between the cost method vs. the equity method?
The main difference between the cost and equity methods is that it applies to investors with less than 20% shares in a company. The equity method applies to investors with between 20% and 50% of the company's shares.
What is a cost method investment?
Cost method investment is an accounting process requiring investors to record all their investment transactions on a balance sheet. It involves cash proceeds and a loss/gain on the sale of investments.
Table of Contents
- What is the Cost Method of Accounting?
- Cost of Investments in a Balance Sheet
- Pros and Cons of the Cost Method of Investments
- Examples of Investment Accounting Journal Entries
- Lesson Summary
Accounting allows a business to stay up to date on its financial transactions, including expenses, sales, and costs. If a company did not track its finances, it would have no idea of its financial status, and inappropriate accounting would undoubtedly lead to its collapse.
The cost method is an accounting method in which investment securities are carried at historical cost. Historical cost is the original price of an asset, plus any subsequent costs incurred to keep the asset in working order. The cost method is applied in many financial accounting instruments, including investments and fixed or inventory assets. It is a conservative accounting method when the investor owns no more than 20% of the company's investment. Such an investor has very little or no influence on the investment, which is recorded in a balance sheet in the asset section.
For example, suppose Clara buys a 5% investment in I&M insurance company for $1 million. In that case, the investment will be valued at the same amount on her balance sheet without considering its current price in the market price. If her investment accumulates $10,000 in dividends annually, the amount will be recognized as her additional income.
Cost Method vs. Other Accounting Methods
Accounting methods differ in how they record investments in and out of a company. The most common accounting method is the cost method, which is quite different from other accounting methods. It generally records investments at a historical cost rather than at market value, making it different from the fair value and equity method of accounting. The fair value method records the asset's current value in the market. The cost method only requires adjustments for changes in the investment value directly attributable to the investor, such as dividends and stock splits.
On the other hand, the fair value method requires frequent adjustments to reflect the changing value of the underlying investment with the current market changes. The cost method differs from the equity method in that it does not require the investor to adjust the investment for their share of the underlying company's earnings or losses. This means that any gains or losses on the investment are only recognized when it is sold. The cost method also applies to investors with less than 20% of the company shares, while the equity method involves investments between 20% and 50%. The cost method treats any dividends as income and can be taxed. On the hand, the equity method does not record dividends as income but rather as a return on investment and reduces the listed value of the investor's company shares.
Accounting methods are typically used to record the value of the assets in a company. Often the fair value methods tend to be accurate because it records what an investment will sell as of today. The cost method of accounting may sometimes be inaccurate, especially if an asset's original or buying price changes over a long period.
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A company using the cost method of accounting incorporates various rules while recording the cost of investments on the balance sheet. They include:
- Distributions from profits are recognized in the current year.
- When an investor using the cost method receives a distribution from their investment generated from profits, they must acknowledge and record the total distribution amount in the current year. In other words, any annual distributions from profits (dividends) are regarded as income of the same year. These dividends increase cash flow for the investor and the company.
- Changes in value and impairments are recognized in the current year.
- The rule implies that any value changes in the investment must be recorded in the current year. They may include appreciation, depreciation, or impairments and are recognized as losses recorded with a debit. Recognizing such changes is essential because they affect the net income and investment in the balance sheet. They also ensure that the financial statements accurately reflect the current value of the investment.
- Gains on investments are recognized only when they are sold.
- In the cost method, gains on investments are not recognized in the current year. They are not recognized until an asset is sold or an additional investment is purchased. There is no way to determine what the gain or loss on the investment will be. The purchase is therefore recorded as a non-current asset at its original/buying price on the balance sheet.
The cost method is the simplest and most common method used to account for investments. Under the cost method, investments are recorded at cost and are not adjusted for market value changes.
Using the Cost Method for Investments
The cost method for investments mandates every investor to account for the investment at its purchase price as an asset on their balance sheet. This transaction does not require any adjustments unless there is a significant loss on sale or cash proceeds. The loss on sale is the difference between the value of the investment on the books and the cash proceeds. Cash proceeds from the sale are the amount received from selling an investment in a certain period. They are gross proceeds because they are the total amount received before making any deductions and all transaction costs such as legal fees, shipping charges, and broker commissions. To better understand the difference between the value of the books and the cash proceeds, below is an example:
Clara bought an investment from I&M insurance company at $50,000. One year later, she sold the investment to another investor at $35,000. The difference between the original price recorded in the company's books, $50,000, and the selling amount, $35,000, will be $15,000. This will be a loss on the sale of that particular investment.
The $35,000 is the cash proceeds. On other occasions selling an investment may result in a gain on the sale. It is obtained if the difference between the value in the books is lower than the cash proceeds. For instance, if Clara had sold the investment at $60,000, the company would obtain a gain on the sale.
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There are several advantages of using the cost method of investment. They include:
- Less paperwork. The cost method of investment accounting is less paperwork intensive because it does not require recording periodic income and expense items associated with the investment. It also saves time and cost since it is recorded once and does not require separate accounting for each investment not until an asset is sold later in the future years.
- Fewer adjustments. The cost method of investment requires fewer adjustments because it only recognizes investments that have been purchased and do not attempt to measure the fair value of the investment. There is simply a single entry in the balance sheet recording the initial buying price of an asset.
- No manipulation of the numbers. This advantage states that the cost method is simple and easy to understand because it relies on a company's original purchase price of an investment rather than its current market value. The cost method does not require the frequent calculation of the value of an investment. Therefore, the original cost is not manipulated, and some investors may find it more accurate and reliable.
The cost method of investment also comes with a set of disadvantages which include:
- Fair value fluctuations. The cost method of investment accounting does not reflect the fair value of an investment, only the original purchase price. This means that any fluctuations in the fair value of the investment are not reflected in the accounting records. This can make it difficult to assess the actual performance of an investment.
- Inflation. Inflation can cause the cost of an investment to be overstated. This is because the price of an investment is not adjusted for inflation, as the cost method assumes that the cost will remain the same over time. The investment's cost may then appear to be higher than its earnings, leading to it appearing to be a less attractive investment.
- Undistributed earnings. Undistributed earnings are a disadvantage of the cost method of investment accounting because they can be misleading. Undistributed earnings are the portion of earnings that have not been paid out in dividends. This can give the impression that a company is doing better than it is because the dividend payout has not reduced the earnings.
Every accounting method has its pros and cons. A business chooses its accounting method depending on which is right and works best for the company and its owner.
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Journal entries are used to record transactions in the accounting journal. This is the first step in the accounting cycle and includes a transaction description, date, debits, credits, and reference to the transaction source. Investment accounting journal entries include the purchase and sale of an investment, dividends, and interest received.
Random Company Journal Entry
Random Company paid $387,000 for 80% of the Song Company's outstanding voting shares in 2009. Its stockholders' equity was initially valued at $475,000, and its distributions in dividends and income between 2009 and 2010 were as follows:
| 2009 | 2010 | 2011 | |
|---|---|---|---|
| Net income(loss) | $ 63,500 | $ 52,500 | $ 55,000 |
| Dividend distribution | $ 25,000 | $ 50,000 | $ 35,000 |
Random company is required to prepare journal entries from 2009 to 2011 to establish its investment in Song Company.
The investment above was recorded using the cost method of accounting by Random Company.
| 2009 | 2010 | 2011 | |
|---|---|---|---|
| Net income(loss) | $ 63,500 | $ 52,500 | $ (55,000) |
| Dividend distribution | $ 25,000 | $ 50,000 | $ 35,000 |
| 2010 Cash | $ 40,000 | ||
| Dividend income (80%x $ 50,000) | $ 40,000 | ||
| 2011 Cash | $ 28,000 | ||
| Investment in Song 80%x $ 35,000) | $ 28,000 | ||
Therefore, the Dividend income in 2010 was Cash $40,000 (80% x $50,000).
2011 Cash 28,000 (80% x $35,000) is the value of the Song company's investment (Liquidating dividend).
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The cost method of accounting involves recording the cost of investment at its historical cost. The investment is recorded at its original purchase price and primarily applies to investors with less than 20% of the company's shares. This method differs from the equity method in that it only adjusts the investment value according to the company's gains or losses. The fair value method is also different as its investor's shares range between 20%-50%. It also adjusts the investment's value with the current market price. The cost method recognizes distributions of profits, dividends, and changes in value and impairments in the current year.
However, any gains on the investments are not recognized until the investment is sold. It is pretty effective in recording the loss on sale and cash from the sale of an investment. The loss on sale is the difference between the investment value on the books and the cash proceeds, while the cash proceeds on sale is the total value of the investment received after selling. For instance, if the cost of investment on the books is $50,000 and the cash proceeds are $35,000, then the loss on sale will be $15,000. The cost method advantage is that it requires less paperwork, fewer adjustments, and no manipulation of numbers. However, it may lead to inflation due to the fewer adjustments and undistributed earnings, i.e., profits and dividends. Investment accounting journal entries are used to record the investment transactions, including purchase/sale and dividends/interest received on the investment.
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Additional Info
What Is the Cost Method?
Florie Lanier is a billionaire investor. She is one of the Big Fish on an investing TV show where she can put her money into small businesses for an equity (ownership) stake. When an entrepreneur with a company called Fountain of Youth comes on the show pitching a potion that makes people look younger, Florie is all in. She makes an offer of $200,000 for a 15% stake in the business, and the entrepreneur accepts!
Florie knows it's risky to try to put a valuation on this business, since no one really knows if this potion will work on large numbers of people. Some people might even drink the potion and look older!
Florie takes the information back to her offices and gives it to her accountant to record. The accountant determines that they will use the cost method for recording the investment in the Fountain of Youth Company. The cost method mandates that the investment be booked at its historical cost, which in this case is $200,000. The $200,000 will appear as an asset on the balance sheet.
When to Use It?
The cost method is used when:
- The investor has no substantial influence on the investee's policies. A quantitative measure of this is that the investor owns no more than 20% of the company.
- The investment has no easily determinable fair value.
The journal entry to record the investment is straightforward:
| Item | debit | credit |
|---|---|---|
| Investment in Fountain of Youth | $200,000 | |
| Cash | $200,000 |
Distributions from Profits
Fountain of Youth begins running TV ads promoting its potion, and sales are taking off. At the end of the year, Fountain of Youth has $100,000 in profits! As an investor, Florie has a claim on some of the profits. Since she owns 20% of the company, her share is $100,000 * 15% = $15,000.
When the check comes in, the accountant makes this entry:
| Item | debit | credit |
|---|---|---|
| Cash | $15,000 | |
| Income from investment - Fountain of Youth | $15,000 |
This will increase Florie's income and cash flow on her financial statements. Dividends from stock investments are recognized in the same manner as dividend income.
Changes in Value
Florie is happy about receiving her check! She knows the value of the company is going up and wonders if some accounting changes are needed to reflect that. Her accountant tells her to forget it. Under the rules of accounting under the cost method, increases in fair market value are not recognized. The cost method is very conservative, meaning that only declines in the asset's fair market value (called impairment) are recognized in the financial statements. That occurs when fair market value falls below historical cost.
Unfortunately, things are starting to go sour for Fountain of Youth in their second year. Male customers start posting before and after photos after drinking the potion over a long period of time. The after photos showed sagging faces and hair falling out, and the customers are pretty angry about that! It's clear that Florie and her accountant have an impaired investment asset on their hands. They are going to have to write down the value of the investment by 50%, which they do as follows:
| Item | debit | credit |
|---|---|---|
| Loss on impairment - Fountain of Youth | $100,000 | |
| Investment in Fountain of Youth | $100,000 |
The loss will go to the income statement and the balance sheet will show a new value of $100,000 for the investment.
Sale of the Investment
The damaging posts and tweets about Fountain of Youth's potion reduce the value of the company even further as the word spreads. Eventually, a big pharmaceutical company offers $100,000 for the whole company and the owners accept. Florie's share of the sale proceeds is $15,000 ($100,000 * 15%). The transaction is recorded as follows:
| Item | debit | credit |
|---|---|---|
| Cash from sale | $15,000 | |
| Loss on sale - Fountain of Youth Investment | $85,000 | |
| Investment - Fountain of Youth | $100,000 |
The loss on sale is the difference between the investment's value on the books, which is $100,000, and the cash proceeds of $15,000. That will go to the income statement. The investment is also removed from the balance sheet with the $100,000 credit.
Lesson Summary
The cost method of accounting for investments is used when the investor owns less than 20% of the company and the fair market value of the firm is difficult to identify. The investment is recorded at historical cost. Any distribution from profits or dividends are recognized as income. The cost method is conservative, since only declines in the investment's value from impairment are recognized. Increases in value are not. Impairment is when the fair market value of the investment falls below recorded historical cost.
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