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Cost MethodEdit

The cost method is an accounting approach used to account for certain investments in other entities when the investor does not have significant influence over the investee. It records the investment at cost at the time of purchase and, thereafter, the carrying amount is generally not adjusted for the investee’s earnings or losses. Instead, the investor recognizes dividends as income, and the carrying amount is primarily affected by impairment or by dispositions of the investment. In practice, this method contrasts with approaches that adjust the investment for the investor’s share of earnings or losses, such as the equity method, and with approaches that mark the investment to fair value on an ongoing basis. The cost method remains a steady, conservative way to reflect investments whose economic influence is limited and whose accounting risk can be managed without extensive, ongoing valuation judgments.

The cost method has a long-standing role in financial reporting across jurisdictions that rely on a rules-based framework. It is especially common for minority holdings, private securities, and certain debt investments where the investor’s influence over corporate decisions is limited. Proponents highlight that it reduces earnings volatility and avoids subjective judgments about an investee’s performance, while critics contend that it can obscure underlying economic realities when ownership is meaningful but influence is not recognized in the financial statements. The method is sensitive to changes in the investment’s recoverable amount, and impairments can create hits to earnings or assets even when the investee’s operating results are strong. Understanding the cost method involves comparing it to other measurement bases, notably the equity method and fair value-based approaches.

Concept and scope

  • What qualifies as a candidate for the cost method: investments where the investor lacks significant influence, such as small minority stakes or passive holdings, are typically accounted for at cost. When the investor’s influence grows, entities commonly switch to the equity method, changing how earnings and losses are recognized. See equity method.
  • What is recorded: initial recognition at cost, with subsequent accounting largely staying at the same carrying amount unless there is impairment or a disposal. See carrying amount.
  • How income is recognized: cash dividends are usually recorded as income, not as a share of the investee’s net income. This preserves a distinction between returns of capital and earnings from operations. See dividends.
  • Impairment and remeasurement: the investment is tested for impairment when there is evidence that its recoverable amount is below its carrying amount, with impairment recognized if the decline is other-than-temporary. See impairment.
  • Comparisons with other methods: the cost method contrasts with the equity method, which recognizes the investor’s share of earnings and losses, and with fair value approaches, which mark the investment to current market prices. See fair value and equity method.

Measurement under GAAP and IFRS

Under US generally accepted accounting principles (GAAP)

  • Typical use cases: the cost method is common for investments in equity securities where the investor does not have significant influence over the investee, and for certain debt securities. The method emphasizes conservatism by avoiding the recognition of the investee’s earnings in the investor’s income statements.
  • Income statement effects: cash dividends received are recorded as dividend income; the investment’s carrying amount generally remains at cost unless an impairment is recognized. See dividends and impairment.
  • Switch to other methods: if the investor later gains significant influence (for example, through increased ownership or board participation), the accounting may switch to the equity method, with a corresponding change in how earnings are recognized. See equity method.

Under International Financial Reporting Standards (IFRS)

  • Scope and alternatives: IFRS allows a cost model for certain investments outside of those measured at fair value through profit or loss, particularly when there is no active market or reliable measurement of fair value. Impairment is still required when indicators of a decline exist.
  • Dividends and carrying amount: similar to GAAP, dividends are typically recognized as income, while the carrying amount remains at cost unless impairment is identified. See IFRS and impairment.
  • Comparison with the equity method: IFRS generally applies the equity method when the investor has significant influence; otherwise, the cost model or other measurement bases may apply. See equity method.

Treatment when ownership or influence changes

  • Increasing influence: as ownership or influence grows, entities move toward the equity method, which requires recognizing a share of the investee’s profits and losses and adjusting the investment’s carrying amount accordingly. See equity method.
  • Disposals and recoveries: upon sale of the investment, the cost basis and any accumulated impairment are used to determine a gain or loss on disposal. See disposal of investments.
  • Practical considerations: the timing of recognition of gains, the measurement of impairment, and the decision to switch methods can affect reported earnings and balance-sheet strength, with implications for investors and capital allocators. See investment accounting.

Advantages and limitations

  • Advantages from a portfolio-management perspective: the cost method provides a straightforward, reliable framework that reduces earnings volatility associated with mark-to-market fluctuations on small holdings. It lowers the administrative burden and minimizes the risk of policy-driven earnings manipulation through frequent fair-value remeasurement.
  • Limitations and criticisms: critics argue that the cost method can obscure the economic reality of a portfolio when a nontrivial stake yields influence or when market values diverge from book value. It can understate investment income relative to the investee’s underlying performance and may reduce transparency for stakeholders seeking a current view of value.
  • Policy and governance implications: by reducing the incentive to engage in frequent revaluations, the cost method can align with a preference for market-driven governance where management decisions are not distorted by aggressive valuation practices. See corporate governance.

Controversies and debates

  • Volatility versus reliability: supporters of the cost method contend that avoiding mark-to-market volatility yields more reliable, long-run financial reporting and reduces opportunistic earnings management by investees. Critics argue that not reflecting timely performance and value movements creates a lag that misleads investors. See fair value.
  • Influence and reporting integrity: debates often center on whether the absence of earnings recognition under the cost method adequately reflects the investor’s economic exposure. Proponents emphasize that freedom from forced recognition of investee profits prevents offsetting distortions caused by earnings management, while opponents push for transparent, up-to-date reflections of value through market-based measurements. See investor and financial reporting.
  • Tax and regulatory considerations: the choice of measurement basis interacts with tax policy and regulatory expectations, potentially affecting how capital is allocated and how capital markets price risk. Advocates of simpler, rules-based reporting favor the cost method for its clarity, while reformers push for more timely and market-based valuations. See tax policy and regulatory framework.

See also