Cost vs Equity Method: Key Differences and How They Work
Understand the key differences between the cost and equity methods, how they impact financial reporting, and when each approach is appropriate.
Companies investing in other businesses must choose how to account for their investments, which affects financial statements and reported earnings. The cost method and the equity method are two common approaches, each with distinct rules and implications. Selecting the right method depends on factors such as ownership percentage and level of influence over the investee.
Ownership Interests
The percentage of ownership a company holds in another business determines how the investment is accounted for and the level of influence it can exert. Ownership stakes below 20% indicate a passive investment, meaning the investor has little to no control over the investee’s operations. In these cases, the investment is recorded at its purchase price, with adjustments only for impairment or dividends received.
When ownership falls between 20% and 50%, the investor is presumed to have significant influence, even without majority control. This influence can come from board representation, participation in policy decisions, or material transactions between the two entities. Voting rights, contractual agreements, or economic dependence can also establish influence.
Once ownership surpasses 50%, the investor gains control and must consolidate the investee’s financials into its own. This means reporting the subsidiary’s assets, liabilities, revenues, and expenses as part of the parent company’s financial statements. Intercompany transactions are eliminated to prevent double counting.
Applying the Cost Method
When a company holds a minor stake in another business and does not exert influence over its operations, the cost method is used. The investment is recorded on the balance sheet at its original purchase price and remains at that value unless an impairment occurs. Changes in the investee’s financial performance do not affect the investor’s books.
Income under this method comes from dividends. When the investee distributes earnings, the investor records the dividend as income. However, dividends do not change the investment’s carrying value on the balance sheet, as they are treated as revenue rather than a reduction in the investment’s worth.
Investments under the cost method are periodically evaluated for impairment. If there is evidence of a permanent decline in value—such as bankruptcy, regulatory changes, or prolonged financial distress—the investor must write down the asset to its fair value and recognize a loss on the income statement. Impairment losses cannot be reversed.
Applying the Equity Method
When an investor has substantial influence over another company but does not control it, the equity method is used. Unlike the cost method, where the investment remains unchanged unless impaired, this approach requires ongoing adjustments based on the investee’s financial performance. The investor’s share of the investee’s net income or loss is recognized directly in its financial statements, increasing or decreasing the carrying value of the investment accordingly.
For example, if an investor owns 30% of a company that reports a net income of $1 million, the investor records $300,000 as investment income. If the investee incurs a $500,000 loss, the investor recognizes a $150,000 reduction in earnings. This ensures the financial statements reflect the investor’s proportional stake in the investee’s financial results.
Other factors can also affect the investment’s carrying amount. If the investee issues additional shares, the investor’s percentage ownership may be diluted, requiring a reassessment of the accounting method. Similarly, if the investee makes equity distributions beyond regular dividends, such as returning capital to shareholders, the investor must adjust the investment balance accordingly.
Dividends and Investment Income
The way dividends and investment income are recognized depends on the accounting method used. Under the cost method, dividends are recorded as revenue when declared and do not impact the investment’s carrying value. In the U.S., dividends from domestic corporations may qualify for a lower tax rate if they meet certain IRS requirements.
For investments accounted for using the equity method, dividends do not contribute to income, as earnings are already recognized proportionally based on ownership percentage. Instead, distributions reduce the carrying amount of the investment, reflecting a return of capital rather than new income. If distributions exceed the investee’s retained earnings, they may trigger capital gains tax liabilities.
Financial Statement Presentation
The choice between the cost and equity methods affects how investments appear on financial statements, influencing key financial ratios and investor perceptions.
Under the cost method, the investment is classified as a long-term asset on the balance sheet, typically under “Investments” or “Other Assets.” Since the carrying value remains unchanged unless impaired, this approach results in minimal volatility. On the income statement, only dividend income is recognized, meaning fluctuations in the investee’s earnings do not directly affect the investor’s profitability. The cash flow statement records dividends as operating cash inflows.
With the equity method, the investment’s value fluctuates based on the investee’s financial results, appearing as a single line item on the balance sheet under “Investments in Associates” or a similar category. The income statement reflects the investor’s proportional share of the investee’s net income or loss, introducing variability in reported earnings. This can impact financial ratios such as return on assets (ROA) and return on equity (ROE), as the investment balance changes over time. On the cash flow statement, dividends received are classified as investing cash inflows rather than operating income.