Equity Method vs. Cost Method
The main criterion for the method to be employed for bookkeeping of the investment of an investor over an entity is the degree of influence it enjoys over the entity. The degree of influence here means the extent to which the investor buying stocks can exercise its rights over the operation of the entity that sold its stock. The two methods are equity method and cost method and we shall compare equity method vs. cost method.
Equity method vs. cost method
Depending on the degree of his influence that an investor enjoys in any entity, they need to account for their equity investments in their financial statements. A principle that is frequently used for assess that influence is the percentage of the voting stock that the investor possesses in the entity. Degree of influence can also be assessed from factors like representing the board or directors, participating in making decisions, material transactions and technical dependence within the group companies and exchange of managerial talent.
The Renewable Energy Tax Credit Handbook considers that an investment of less than twenty percent of stock in an entity is too little to give an investor any major power over the entity. That is why cost method is employed for accounting of such investments. Under this system of accounting the expense towards acquisition is debited to asset account. Dividends received, if any, get credited to dividend revenue account while debited to asset accounts. As such the dividends don’t influence carrying balance of in vestment. On selling that equity, a loss or profit is documented as the sum of difference between the cost of acquisition and selling price.
Once again, considering the “Renewable Energy Tax Credit Handbook, acquisition of twenty to fifty percent of stock of any company should be treated as large enough to give non-controlling investor a substantial power in the company. Non-controlling interests mean the investor can not be appointed as a director of the board of the company or assigned any major appointment. Equity method is employed for accounting of such investments. In such cases the worth of stock is adjusted from time to time while accounting for dividends or earning and losses of the entity. So, the expense towards acquisition is debited to asset account of equity investments. So, dividend is credited to that account and considered as a part of return on original investment. As such, the carrying balance on investment dividend or income is influenced by dividend or income. The share of net income earned by the investor gets deducted from the revenue earned on investment account.
Comparing the equity method vs. cost method
As you’ll see, when using equity method, the original investment is documented as cost. The investment in this case gets decreased or increased from time to time to take into account dividends or losses of the entity. The cost method, on the other hand, takes into account only such investments wherein the investors have no control on the operation of the entity. In this method, the original investment is debited to the investment account, while dividends are credited to revenue account. In contrast to equity method of accounting, in case of cost method, dividends do not influence the balance carried over investment.