A direct or indirect investment of 20% to 50% of the voting rights of a company – an associated company – should enable an investor to significantly influence the operating and financial decisions of the company. Unless there is evidence to demonstrate that the investor’s ability to exercise significant control is restricted, application of the equity method is generally required for investments of greater than 20% and up to 50% of the investee’s voting shares.
The cost method is used for the accounting of investments where significant influence over another company does not exist, requiring the investor to record the investment at cost and to recognize ordinary income from the investment only when the investee pays dividends. Under the cost method the investor does not recognize any pro rata share in the investee’s periodic income or loss and capital gains (losses) are recognized only after the sale of the investment. The amount by which the aggregate costs of the investment exceed the market value must be accounted for by the investor as a valuation allowance (a contra account).
|Cost Method of Accounting (Example)|
|A firm acquired a 20% stake in Company XYZ for $40,000 on 1 January 2017 and applies the cost method to account for the investment. XYZ reports a profit of $10,000 at 31 December 2017 and distributes a dividend of $6,000 on 30 June 2018.|
|1 Jan 17||Investment in XYZ||40,000|
|To record purchase of 20% interest in Company XYZ|
|31 Dec 17||Cash||1,200|
|Dividend from XYZ||1,200|
|To record 20% share of $6,0000 dividend distributed by XYZ|
The equity method is used to account for investments where significant influence – not control – over another company exists, whereby the investor initially records the investment at cost and then increases or decreases the carrying amount of the investment by recognizing its share of the investee’s earnings or losses, respectively, in the period in which they are reported. Dividends received from the investee reduce the carrying value of the investment.