The cost and equity methods of accounting are used by companies to account for investments they make in other companies. In general, the cost method is used when the investment doesn't result in a significant amount of control or influence in the company that's being invested in, while the equity method is used in larger, more-influential investments. Here's an overview of the two methods, and an example of when each could be applied.
The cost methodAs mentioned, the cost method is used when making a passive, long-term investment that doesn't result in influence over the company. According to generally accepted accounting principles (GAAP), the cost method should be used when the investment results in an ownership stake of less than 20%.
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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.
For example, if your company buys a 5% stake in another company for $1 million, that is how the shares are valued on your balance sheet -- regardless of their current price. If your investment pays $10,000 in quarterly dividends, that amount is added to your company's income.
The equity methodThe equity method of accounting should be used when an investment results in a 20% to 50% stake in another company, unless it can be clearly shown that the investment doesn't result in a significant amount of influence or control.
Under the equity method, the investment is initially recorded in the same way as the cost method. However, the amount is subsequently adjusted to account for your share of the company's profits and losses. Dividends are not treated as income under this method. Rather, they are considered a return of investment, and reduce the listed value of your shares.
As an example, let's say that your company acquires a 40% stake in another company for $20 million, and that you're given a seat on the board (influence). You would record the purchase at the $20 million purchase price in the same way described under the cost method. However, if the company produces net income of $5 million during the next year, you would take 40% of that amount, or $2 million, which you would add to your listed value, and record as income.
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