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Cost Method & Equity Method

Original post by Matt Petryni of Demand Media

Whether businesses use the cost method or the equity method to account for their investments depends on the nature and extent of their ownership.

Large businesses often own shares of other companies. The companies they own may function either as a fully-integrated part of their own company, or as a independent operation that the purchaser merely owns in part. In either case, the company purchasing stock is required to account for their ownership in another business using either the cost method or the equity method. Individuals reviewing the financial statements of an investment opportunity can benefit from an understanding of the methods businesses use to account for shares that they purchase in another company.

Investments in Other Companies

Many corporations purchase stock in another company as a means of hedging risk and expanding their business. In some cases, the company will buy the entire business and roll its operations into those of the purchasing company. In many cases, though, companies will purchase only a portion of another company's stock and allow the company to continue to operate as an independent business. In these cases, both companies will maintain their own accounting records and financial statements. When accounting for an investment in another company's stock, a business may use the cost method or equity method, depending on the nature and extent of their ownership.

Cost Method

The cost method is one way of accounting for a purchases of stock in another company. In the cost method, the investor company records their purchase at the cost of acquisition. Income from the investment is accounted for as dividend or investment income, while income or expenses from sales of another company's stock are accounted for as capital gains or losses. Investor companies use the cost method when they do not control a substantial portion of another company and cannot significant exercise influence over its operations.

Equity Method

In many cases, a company's purchase of another company's stock will entitle them to significant control over management decisions. In these cases, generally accepted accounting principles call for the use of the equity method to value and record the investment. In the equity method, the investment is recorded at cost at the time of original acquisition, but the investment's earnings or losses are also accounted for by the investment's purchaser. Under the equity method, the investment business's losses are charged against's the investor's income while earnings are added to the investors's income. Businesses use the equity method when their share in another company exceeds 20 percent but is still less than a legally controlling share, over 50 percent.

Consolidation Method

The consolidation method is a third option for accounting for investments in other companies. Businesses that purchase a controlling share -- usually over 50 percent ownership -- in another company will use the consolidation method. In the consolidation method, the investment company's accounts become a fully integrated part of the investor company's company's books. Financial statements, including balance sheets and the income statement, will also be consolidated to reflect the business's new holdings in a another company.

                   

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About the Author

Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.

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