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 method

As mentioned, the cost method is used when making a passive, long-term investment
that doesn't result in influence over the company. The cost method should be used
when the investment results in an ownership stake of less than 20%, but this isn't a set-
in-stone rule, as the influence is the more important factor.

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 method

The equity method of accounting should generally 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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Differences Between Cost Method and Equity Method

Unlike the equity method, the cost method accounts for investments when the investor
has no ability to exercise control over the investee's operations. Under the equity
method, the initial investment is recorded at cost and this investment is increased or
decreased periodically to account for dividends and the earnings or losses of the
investee. In contrast, the cost method accounts for the initial investment as a debit to
an investments account and the dividends as a credit to a revenues account. Unlike
the equity method, cash distributions under the cost method do not affect the carrying
balance of the investment.

Breaking Down the Equity Method

The equity method is the standard technique used when one company has
a significant investment in another company. When a company holds
approximately 20% or more of another company's stock, it is considered to have
significant control, which signifies the power one company can exert over
another. This power includes representation on the board of directors, partaking
in policy development, and the interchanging of managerial personnel. If a firm
owns 25% of a company with a $1 million net income, the firm reports earnings
under the equity method of $250,000.

When the equity method is used to account for ownership in a company, the
investor records the initial investment in the stock at cost, and that value is
periodically adjusted to reflect the changes in value due to the investor's share in
the company's income or losses.

Equity Method Earnings Adjustment

The equity method acknowledges the substantive economic relationship between
two entities. When a company - the investor - has a significant influence on the
operating and financial results of another company - the investee - it can directly
affect the value of the investor's investment. With an investment holding above
20%, the investor usually records its share of the investee's earnings as revenue
from investment, which increases the carrying value of the investment.
Equity Method Loss Adjustment
When the investee company reports a net loss, the investor company records its
share of the loss as loss on investment, which decreases the carrying value of
the investment. Using the equity method, a company reports the carrying value of
its investment independent of any fair value change in the market. With a
significant influence over another company's operating and financial policies, the
investor is basing its investment value on changes in the value of that company's
net assets from operating and financial activities and the resulting performances,
including earnings and losses.

Equity Method Dividend Adjustment

When the investee company pays a cash dividend, it decreases the value of its
net assets. Using the equity method, the investor company receiving the dividend
records an increase to its cash balance but, meanwhile, reports a decrease to
the carrying value of its investment. Other financial activities that affect the value
of the investee's net assets should have the same impact on the value of the
investor's share of investment. The equity method ensures proper reporting on
the business situations for the investor and the investee, given the substantive
economic relationship they have.

What is the cost method?

The cost method is a type of accounting used for investments. This method is
used when the investor exerts little or no influence over the investment that it
owns. In this case, the terminology of “parent” and “subsidiary” are not used,
unlike in the consolidation method where the investor exerts full control over
its investee. Instead, the term “investment” is simply used.

How does the cost method work?

The investor reports the cost of the investment as an asset. When dividend
income is received, it is immediately recognized on the income statement. This
receipt of dividend also increases the cash flow, under either the investing
section or operating section of the cash flow statement (depending on the
investor’s accounting policies).
If the investor later sells the assets, he or she realizes a gain or loss on the sale.
This affects net income in the income statement, is adjusted for in net income
on the cash flow statement, and affects investing cash flow.

The investor may also periodically test for impairment of the investment. If it is
found to be impaired, the asset is written-down. This affects both net income
and the investment balance on the balance sheet.

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Simple Example

Traderson Co. purchases 10% of Bullseye Corporation for 2,000,000. At the

end of the year, Bullseye announces it will be paying out a dividend of 50,000
to its shareholders.

When Traderson purchases the investment, it records the investment of

Bullseye at cost. The journal entries may appear as follows, depending on
Traderson’s investment strategy and history. It may classify the investment
differently, depending on the type of marketable security it deems, but it will
generally classify it as an asset.

Dr. Trading Securities 1,000,000

Cr. Cash 1,000,000

At the end of the year, Traderson receives 10% of the 50,000 dividends (as
Traderson holds 10% of Bullseyes shares)

Dr. Cash 10,000

Cr. Dividend Revenue 10,000

What are the other accounting methods?

When an investor exercises full control of the company it invests in, the
investing company may be known as a parent company to the investee. The
latter is then known as the subsidiary. In such a case, investments made by the
parent company in the subsidiary are accounted for using the consolidation
method.

The consolidation method records “investment in subsidiary” as an asset on

the parent company’s balances, while recording an equal transaction in the
equity side of the subsidiary’s balance sheet. The subsidiary’s assets, liabilities
and all profit and loss items are reported in the consolidated financial
statements.

Alternatively, when an investor does not exercise full control of the investee,
but possesses some influence over its management, the investor possesses a
minority active interest in the investee. In such a case, investments will be
accounted for using the equity method.

The equity method records the investment as an asset, more specifically as

investment in associates or affiliates, and the investor accrues a proportionate
share of the investee’s income equal to the percentage of ownership. This
share of the income is known as the “equity pick-up”.

What is the Equity Method?

The equity method is a type of accounting used for
intercorporate investments. This method is used when the investor holds
significant influence over the investee, but does not exercise full control over
it, as in the relationship between a parent company and its subsidiary. In this
case, the terminology of “parent” and “subsidiary” are not used, unlike in the
consolidation method where the investor exerts full control over its investee.
Instead, in instances where it’s appropriate to use the equity method of
accounting, the investee is often referred to as an “associate” or “affiliate”.

Although the following is only a general guideline, an investor is deemed to

have significant influence over an investee if it owns between 20% to 50% of
the investee’s shares or voting rights. If, however, the investor has less than
20% of the investee’s shares but still has significant influence in its operations,
then the investor must still use the equity method and not the cost method.

How does the equity method work?

Unlike with the consolidation method, in using the equity method there is no
consolidation and elimination process. Instead, the investor will report its
proportionate share of the investee’s equity as an investment (at cost). Profit
and loss from the investee increase the investment account by an amount
proportionate to the investor’s shares in the investee. This is known as the
“equity pick-up.” Dividends paid out by the investee are deducted from this
account.

Practical example

Lion Inc. purchases 30% of Zombie Corp for $500,000. At the end of the year,
Zombie Corp reports a net income of $100,000 and a dividend of $50,000 to
its shareholders.

When Lion makes the purchase, it records its investment under “Investments
in Associates/Affiliates”, a long-term asset account. The transaction is recorded
at cost.

Dr. Investments in Associates 5

Cr. Cash 5

Lion receives dividends of $15,000, which is 30% of $50,000, and records a

reduction in their investment account. The reason for this is that they have
received money from their investee. In other words, there is an outflow of cash
from the investee, as reflected in the reduced investment account.

Dr. Cash 15,000

Cr. Investments in Associates 15,000
Finally, Lion records the net income from Zombie as an increase to its
Investment account.

Dr. Investments in Associates 30,000

Cr. Investment Revenue 30,000

The ending balance in their “Investments in Associates” account at year end is

$515,000. This represents a $15,000 increase from their investment cost.

This reconciles with their portion of Zombie’s retained earnings. Zombie has
Net Income of $100,000, which is reduced by the $50,000 dividend. Thus,
Zombie’s retained earnings for the year are $50,000. Lion’s portion of this
$50,000 is $15,000.

What are the other possible accounting methods?

When an investor exercises full control over the company it invests in, the
investing company may be known as a parent company to the investee. The
latter is then known as a subsidiary of the parent company. In such a case,
investments made by the parent company in the subsidiary are accounted for
using the consolidation method.

The consolidation method records “investment in subsidiary” as an asset on

the parent company’s balance sheet, while recording an equal transaction on
the equity side of the subsidiary’s balance sheet. The subsidiary’s assets,
liabilities, and all profit and loss items are reported in the consolidated
financial statements of the parent company.

Alternatively, when an investor does not exercise full control over the investee,
and has no influence over the investee, the investor possesses a
passive minority interest in the investee. In such a case, investments will be
accounted for using the cost method.
The cost method records the investment at cost, and accounts for it
depending on the investor’s historic transactions with the investee and other
similar investees.

Cost, Equity, and Consolidated Reporting

Methods
A minority interest is the proportion of a subsidiary company's stock not owned
by its parent company. This is sometimes called a non-controlling interest. The
amount of interest held in the subsidiary is typically less than 50 percent;
otherwise, the corporation would no longer be a subsidiary to the parent
company.

Minority Interest Example

If Federated Department Stores, the owner of Macy's and Bloomingdale's,

purchased 5 percent of Saks Fifth Avenue, Inc., it stands to reason that
Federated would be entitled to 5 percent of Saks' earnings.

This begs the question of how Federated would report their share of Saks'
earnings on their income statement. The answer depends on the percentage of
the company's voting stock that Federated owns.

The Cost Method (Ownership: 20 Percent or Less)

Under this scenario, the company would not be able to report its share of Saks'
earnings, except for the income from any dividends it received on the Saks
stock. The asset value of the investment would be reported at the lower of cost or
market value on the balance sheet.

This means that, if Federated purchased 10 million shares of Saks stock at $5

per share for a total cost of $50 million, it would record any dividends received
from Saks on its income statement. On the company's balance sheet, it would
record $50 million under Investments.

If Saks rose to $10 per share, the 10 million shares would be worth $100 million
($10 per share x 10 million shares = $100 million). Federated's balance sheet
would be adjusted to reflect $50 million in unrealized gains, less a deferred tax
allowance for the taxes that would be owed if the shares were sold.

On the other hand, if the stock dropped to $2.50 per share, this would reduce the
investment's value to $25 million. The balance sheet value would be written down
to reflect the loss of a deferred tax asset established to reflect the deduction that
would be available to the company if it was to take the loss by selling the shares.

The income statement would never show the 5 percent of Saks' annual profit that
belonged to Federated. Only dividends paid on the Saks shares would be shown
as dividend income (which is, actually, added to total revenue or sales in most
cases). Unless you delved deep into the company's 10-K, you may not even
realize that the Saks dividend income is included in total revenue as if it were
generated from sales at Federated's own stores.

Equity Method (Ownership: 21-49 Percent)

In most cases, Federated would include a single-entry line on their income

statement reporting their share of Saks' earnings. For example, if Saks earned
$100 million and Federated owned 30 percent, it would include a line on the
income statement for $30 million in income (30 percent of $100 million), even if
these earnings were never paid out as dividends (meaning they never actually
saw $30 million).

Consolidated Method (Ownership: 50+ Percent)

With the consolidated method, Federated would be required to include all of the
revenues, expenses, tax liabilities, and profits of Saks on the income
statement. It would then also include an entry that deducted the percentage of
the business it didn't own.

For example, if Federated owned 65 percent of Saks, it would report the entire
$100 million in profit and then include an entry labeled Minority Interest that
deducted the $35 million (35 percent) of the profits it didn't own.

Differences Between Cost Method & Equity Method

When a company purchases a minority stake in another firm, it becomes an investor and the firm it
invests in becomes the investee. Generally accepted accounting principles, or GAAP, require the
investor to use certain methods -- the cost method or equity method -- to account for and incorporate
its investment. The investor uses the cost method when its ownership stake is not significant and
uses the equity method when it is.

Using the Cost Method

Companies use the cost method as their accounting methodology to capture the financial activities
related to the smaller investments they make in other businesses. To use the cost method, the
investor must exert minimal, if any, influence or control over the investee. The investor must record
its investment on the balance sheet at its original cost using the cost method. The investment
remains at cost on the investor's books. The investor only adjusts its books if its investment takes a
serious downturn that requires a permanent write-down of the investment.

Cost Method on the Income Statement

On its income statement using the cost method, the investor only documents dividend income
received from the investee. The investor shows no other adjustments or transactions related to its
investment until it sells its stake. At that time, the investor recognizes the gain or loss on the sale of
its ownership stake. However, if the investor adds to its investment and reaches a 20 to 25 percent
stake and becomes influential in decisions about the investee, it must switch to the equity method.

Using the Equity Method

A company must use the equity method when it owns a significant but not majority stake in another
company. "Significant" is defined as an ownership stake between a minimum 20 to 25 percent to a
maximum 50 percent stake, and the investor must exercise a high degree of influence, but not
control, over the investee’s strategic and operating decisions. As with the cost method, the investor
records its investment at cost. However, at the end of each accounting period, the investor records
dividends it receives as value reductions and adjusts the investment value to reflect changes in the
investee’s value.

Equity Method on the Income Statement

To give an accurate view of overall business financial and operational performance, GAAP requires
businesses to use consolidated financial statements. Minority stakes appear as separate line items
on the investor's income statement and balance sheet. Under the equity method on the income
statement, the investor documents its proportionate share of the investee's profits or losses. The
investor also shows any amortization and similar adjustments it takes on its investment.

How They Compare

Imagine that RST Goods Inc. buys a 25 percent stake in Startup Inc. for $100,000. Under both the
cost and equity methods, the initial balance sheet recording shows “Equity investment in Startup
Inc., $100,000.” Two years later, under the cost method, the value shown remains at $100,000.
However, under the equity method, RST’s balance sheet now shows $200,000, which is the original
investment plus its 25 percent of Startup’s $400,000 in retained earnings during that period.
Tax Impact

The dividends received under the cost method create taxable income. For example, if UVW Corp. pays
out 2 percent a year in dividends, your income is 2 percent of $10 million, or $200,000. In the 25 percent
tax bracket, you would incur a $50,000 tax liability. The equity method has a larger potential effect on
income and thus on income taxes. Suppose XYZ Corp routinely earns a 10 percent annual return on
equity. In the first year, you would record income of 10 percent of $10 million, or $1 million. Your tax
liability is $250,000. Since income is normally more volatile than dividend yield, the equity method has
more potential to affect your company’s tax bill.

Adjustments to Value

Under the equity method, you update the carrying value of your investment by your share of the

investee’s income or losses. In addition, you decrease carrying value by any dividends you receive on the
shares. You do not otherwise adjust the carrying value to reflect changes to the fair market value of the
investee. In the cost method, you never increase the book value of the shares because of an increase in
fair market value. However, you can mark down the book value if the investee’s fair market value is
impaired. Fair market value is the amount a purchaser would pay to buy a company.

Other Comprehensive Income

“Other comprehensive income” is an equity account that records gains and losses resulting from events
over which your company has no control. Examples include changes to foreign currency exchange rates,
changes to the value of available-for-sale securities and gains or losses on pension plans. Under the
equity method, you must record your share of the investee’s OCI as OCI on your own books. You report
OCI on the income statement below net income. You report accumulated OCI on the balance sheet.
Under the cost method, you make no accounting entries regarding investee OCI.

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What are the different investment methods?

A simple way of classifying investments is to divide them into three categories

or “investment methods” which include:

 Debt investments (loans)

  Equity investments (company ownership)
 Hybrid (convertible securities, mezzanine capital, preferred shares)

Debt investments

Debt-based investments can be further broken down into two sub-categories:

the public and the non-public (private) investments.

Public debt investments are any investments that can be purchased or traded
in open debt markets. These are such things as bonds, debentures, and credit
swaps, among others. A company will often classify public securities as held-
to-maturity, available-for-sale, or held-for-trading. Each of these classifications
has certain criterion and treatment under accounting standards.

Private debt investments are any transactions that generated an asset on the
balance, and are not openly or easily traded in markets. Examples of these are
purchasing of another entity’s accounts receivables or loan receivables, which
are expected to generate some form of future income.

Equity investments

Equity investments can also be categorized as public and non-public

investments. The latter is commonly known as Private Equity, which are
considered high risk, high reward investments. In fact, equity investments are
generally seen as riskier than debt investments, with the advantage of possibly
generating more returns.

Public equity investments are any equity-based investments that can be

purchased or traded in markets. These are often the type of investments that
someone may have in mind when discussing investments, and cover such
instruments as common stock, preferred stock, stock options, and stock
warrants.
Private equity investments are often larger-scale investments that are not
within the scope of a low-capital investor. Leveraged buyouts, mergers and
acquisitions, and venture capitalism are just some of the more commonly
undertaken types of private equity transactions.

Hybrid investment methods

Let’s look at some additional investment methods. There are investment types
that mix both elements of debt and equity. An example of this is mezzanine
debt, in which an investor provides a loan to a second party in exchange for
equity. Another example is a convertible bond, in which an investor has
purchased a bond that has a feature where it is exchangeable for a certain
number of shares of the issuing company.

There are also investment types that possess neither debt nor equity
components. An example of this type of investment are any investments into
the asset side of the balance sheet, such as purchase of equipment or
property under PP&E. Alternatively, purchasing intangible assets like a brand
or patent can also classify as an investment, depending on the strategy.

Finally, there is a large class of investments called derivatives, which – as the

name implies – are derived from other securities. There are many kinds of
derivatives, all of which merit an article of their own. However, an example of
commonly known derivatives are futures and options, which are investment
instruments that base their value off an underlying stock or commodity.