The Cost Method is a common technique used by a parent company to account for its investments in subsidiary companies. Under this method, the parent company maintains the investment in the subsidiary account at the acquisition cost. This approach does not periodically recognize the parent company’s share of the subsidiary’s income or losses.
Conditions for Using the Cost Method
Ownership Structure
The Cost Method is typically employed when the parent company owns less than 20% of the outstanding voting common stock of the subsidiary. In this situation, the level of ownership is considered insufficient to exert significant influence over the subsidiary.
Significant Influence without Effective Control
In certain circumstances, the Cost Method can also be used if the parent company possesses between 20% and 50% of the voting common stock but lacks effective control or significant influence over the subsidiary. This contrasts with the Equity Method, which is used when the parent holds significant influence (usually between 20% and 50%) and actively partakes in the financial and operational decisions of the subsidiary.
Accounting Procedures
Initial Recognition
At initial recognition, the investment in the subsidiary is recorded at cost. The cost includes the purchase price and any directly attributable expenditures necessary to acquire the investment.
Formula:
Subsequent Measurement
After initial recognition, the investment continues to be carried at the original cost. The parent company does not adjust the investment value for its share of the subsidiary’s earnings or losses.
Dividend Recognition
Any dividends received from the subsidiary are recognized as income by the parent company when declared. This contrasts with the Equity Method, where dividends reduce the carrying amount of the investment.
Examples
- Example 1: A parent company purchases 5% of the voting common stock of a subsidiary for $50,000. The investment remains recorded at $50,000 on the parent company’s balance sheet.
- Example 2: A parent company acquires 15% of a subsidiary’s voting common stock for $100,000. During the period, the subsidiary declares a $10,000 dividend. The parent company recognizes $1,500 as dividend income ($10,000 * 15%).
Comparative Analysis with the Equity Method
Equity Method
- Used when the parent company holds significant influence (usually 20%-50% ownership).
- Parent company recognizes its share of subsidiary’s net income/losses in its financial statements.
- Investment value is adjusted periodically by the parent company’s share of the subsidiary’s earnings or losses.
Cost Method
- Used when ownership is less than 20% or influence is significant but not effective control (20%-50%).
- Investment is recorded and held at cost without adjusting for the subsidiary’s performance.
- Dividends received are recognized as income.
Related Terms
- Equity Method: An accounting method where the parent company recognizes its share of the subsidiary’s net income or loss.
- Consolidation: A method used when the parent company has control over the subsidiary, typically with ownership over 50%.
FAQs
Q1: When is the Cost Method preferable over the Equity Method? A1: The Cost Method is preferable when a parent company owns less than 20% of a subsidiary’s voting stock and does not have significant influence. It can also be used between 20%-50% ownership if there is a lack of effective control.
Q2: How are dividends treated under the Cost Method? A2: Dividends are recognized as income when declared by the subsidiary.
Q3: Does the Cost Method require periodic adjustments for the subsidiary’s performance? A3: No, the investment remains at cost and does not account for the subsidiary’s income or losses.
References
- Financial Accounting Standards Board (FASB) guidelines on investments.
- International Financial Reporting Standards (IFRS) on financial instruments.
- Accounting textbooks and professional literature detailing Cost Method and Equity Method.
Summary
The Cost Method provides a straightforward approach for accounting for investments in subsidiary companies, particularly when ownership is minimal or when significant influence without control exists. By maintaining the investment at cost and recognizing dividends as income, it offers simplicity and ease of use compared to more complex methods like the Equity Method. Understanding when and how to apply the Cost Method is essential for accurate financial reporting and compliance.
