Cost Method and Equity Method in Stock Investments

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Differences between CostMethod and Equity Method in Accounting for Stock Investments- Case Analysis

  1. Introduction

This research is mainly about two accounting methods for long-term investment on stocks. First, it will explain what is long-term investment, also give the definition of two methods, one is cost method, the other is equity method. Second, introduce the three main modes for long-term investment: mode one, the investing company purchases control the invested company (normally the investing company owns more than 50% common stocks of the purchased company),the invested company is a subsidiary of the investing company, in this mode consolidation should be considered; mode two, the purchasing company has a significant influence on the purchased company which be regarded as associate company(normally the stock purchased amount is between 20% to 50%); mode three, the purchasing company has no significant influence on the invested company(normally the purchased amount is 20% or less than 20%). Third, combine with the case which was given, it will discuss which mode the purchase belongs to, whether it has influence and how it influences the purchased company from purchasing. Finally, according to which mode it is and deep analysis of the case, I suggest which method is more suitable for this case and give the solution.

  1. Two methods for long-term investments- cost method and equity method

Long-term investments refers to get the company’s share from the company you invested. The equity investment to the invested company is usually regarded as long-term holding, the investing company controlling or significant influencing the invested company through ownership of the the stock, or just build close relation with the invested company, thus the operation risk can be diversified, normally the long-term investment will be held for many years and will not t be sold in the near future(Irs.gov, n.d.). It is said “ Warren Buffett’s favorite holding period is forever” that is a proper description for the feature of Long-term investment(Buffett, 1988).

2.1 Cost method

Cost method be used when the investing company have no significant influence on the operation activity of the invested company, it means in this method the account of long-term investment booked according to the original cost, and always maintain the original amount, do not reflect by the operating performance of the invested company. According to "Renewable Energy Tax Credit Handbook", the acquisition under 20% is too small influence to reflect the investee(Novogradac, 2010). For prepare the journal entry for the long-term investment under cost method, the purchasing cost are debited to equity investments account, when have any dividends, credit dividends revenue account and debit cash account(Hoyle, Schaefer and Doupnik, 2007).

2.2 Equity method

Equity method be used when it considered the investing company have significant influence on the invested company. Under this method, the investing company need to adjust it book value of long-term investment account according to the percentage of the equity and the change of net assets of the invested company. According to "Renewable Energy Tax Credit Handbook", it consider that the acquisition between 20% to 50% is large enough to have significant influence on the investee(Novogradac, 2010). It is a non-controlling mode which also means the investor do not occupied the key position or have positions in the Boards of Directors. Under equity method, the investing company should confirm the net profit or loss of the invested company as the profit or loss on investment of itself by the acquisition percentage each year. For prepare the journal entry for long-term investment under equity method, debit equity investment for cost of purchase, credit equity investment account for the dividends cause the dividends are considered as a part of return of the investment(CliffsNotes, n.d.).

  1. Three control mode for long-term investment and the proper accounting method under each mode

3.1 Mode1: Control- ownership more than 50% as a subsidiary

Control, means the investing company have right to determined the financial and operating policies of the investee and also can gain the profit from the investee. The investor can take control over the company being invested, and the invested company becomes the subsidiary of the investor.According to IAS27&28, the invest company purchase more than 50% common stock of the purchased company, means it ownership more than 50% as a subsidiary, in this mode consolidation should be considered. Usually, when the investing company directly owns 50% voting capital of the company being invested, or owns less than 50% voting capital but has substantial control over the company, it means that the investing company also can control the company being invested. Usually it can be judged by one or several of the following items according to IAS27&28(Iasplus.com, 2011): 1) The investing company owns over 50% of the voting capital of the company being invested by contract with other investors.2)The investing company has right to control the financial and operating policy of the invested company according to the rules or agreement. 3)To have right to appoint the board member of the invested company. This situation happens when the investing enterprise has less than 50% voting capital of the invested company but still can take control over the invested company by means of appointing the board member according to the rules or agreement. 4)To have more than half of the voting right in the board so as to substantially control the board meeting and the financial and operating policy of the invested company.

In this mode the investing company need to consider consolidation of financial statement at the end of the year. According to IAS 27 both cost method and equity method can be used for consolidation the investment of the subsidiary by the investing company. Both the investor and the investee has its own statement, at the end of year the consolidate statement combine its balance an eliminate the internal transaction between the two company(Findmybestcpa.com, 2007).

3.2 Mode2: significant influence- ownership form 20% to 50% as associate company

Significant influence means the investing company has right to be involved in decision making for the financial and operating policy of the investee but not making the policy, thus the investee be consider as associated company. When the investor directly owns more than 20%, but less than 50% equity of the invested company or indirectly owns this amount through the subsidiary company, it considered as the investor has significant influence on the invested company. From IAS 28 the situation meeting any of the following can also be viewed as important influence(Iasplus.com, 2011):1)The investor has representative in the board of the invested company. 2)To be involved in the process for policy making of the invested company. 3)Have important deal with the invested company. 4)Have staff on management position in the invested company. 5)To provide the important technical document for the invested company.

Under the US GAAP, the ownership of the equity of the invested company between 20% to 50% must use equity method for accounted (FASB Opinion No. 17&18, Statement on Accounting Standards No. 81). When it has some factor that decreased the influence less than 20%, the equity method may also can be used(FASB interpretation 35)(Financial Accounting Standards Board, 2002).

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3.3 Mode3: no significant influence- ownership under 20%

Normally, when the purchased amount is 20% or less than 20%, it be normally considered has no significant influence. Under IAS 28 the following circumstance show that the enterprise has no control and no influence(Iasplus.com, 2011): 1)The investing company directly owns less than 20% of the equity of the invested company and has no significant influence. 2)The investing enterprise has more than 20% of the equity of the invested company but no substantial control or significant influence on the invested company.

Under US GAAP, the investment for the invested company which the ownership under 20% must use cost method for accounted (FASB Opinion No. 17&18, Statement on Accounting Standards No. 81)(Financial Accounting Standards Board, 2002).

  1. Case analysis and resolution

4.1 Journal entries analysis

In this case, the journal entries of the Forth Company can be prepared under both two methods and compared. Under the cost method, when the shares were acquired, the entry can be prepared as debited equity investments account 85,000, credit cash for investment 85,000; when the dividends paid by the invested company, the journal entry can be prepared as: debit cash $9,000,and credit dividends income $9,000. Under the equity method, the entry of acquisition was same as the cost method; when the profit realized by the invested company, it should be recorded as debit investment and credit investment income by the percentage of the equity acquisition, when the dividends received, it should be recorded by debit cash $9,000, credit investment.

4.2 Recording method selected analysis

For this case, the Forth Company have the ownership for 85,000 shares of 100,000 shares of Brown Company's common stock till January 1, 20X2. It means at the Jan. 1 of 20X2, the Forth Company owned 85% of the Brown Company's equity, so it should belong to mode 1 at this time, the Brown as a subsidiary of the Forth Company, and need to considered consolidated the statement. When the Forth Company sold the 70,000 shares out, only 150,00 shares were left which occupied 15% of the Brown’s equity, according to the three mode which mentioned above, it look like the Forth Company do not have significant influence on the Brown Company anymore, but two things we should notice one is cause the equity sold to 7 investor each of them purchase 10,000 shares, so that Forth Company still is the biggest shareholder outside the Brown Company, and the share quantity were equal to Brown itself. The other was it said Forth still purchase large amount of the output of Brown under a valid contract until 20X9, also permitted two staff take a position on Brown's board of directors, so according to IAS28 it consider that the Forth still have a significant influence on the Brown Company(Iasplus.com, 2011).

Thus, from the analysis above we give the conclusion that although the Forth company only have 15% ownership of equity of the Brown Company, cause it as a relevant company which have contract and purchase a great deal output from Brown every year, and also have two members in the Brown's board of directors, and also still was the biggest shareholder of the Brown Company, so it be considered also can influence the Brown company’s finance and operating policy, which still have a significant influence on Brown Company. So that equity method will be chosen for the Forth Company according to IAS and GAAP(Epstein, 2004).

Conclusion

In this research it mainly introduce cost method and equity method for long-term investment, and discussed feature of these two method, also prepare the journal entry to show the different accounting treatment on dividend and give the reason for it. It also give the three mode of control, and found the each proper method for the three different mode which mainly determined by the percentage of the ownership of the equity of the invested company. By analysis the case, it can better understand the the two method, to know the chosen of cost method or equity method not only determined by the percentage of equity of the invested company, also influenced by whether the investing company real influence the finance and operating policy. The process of analysis the case also show that how to use these two method in the real business and account area, and from the accounting principle to give the solution that in this case it recommendation to use equity method.

References

Buffett, W. (1988). Chairman’s letter To the Shareholders of Berkshire Hathaway Inc.

CliffsNotes, (n.d.).Accounting for Equity Securities. [online] Available at: CliffsNotes: Accounting for Equity Securities Read more : http://www.ehow.com/info_8643154_differences-cost-method-equity-method.html Read more : http://www.ehow.com/info_8643154_differences-cost-method-equity-method.html [Accessed 28 Mar. 2015].

Epstein, B. (2004).Wiley GAAP 2005. Hoboken, N.J.: Wiley.

Financial Accounting Standards Board. (2002).Choice Reviews Online.

Findmybestcpa.com, (2007).Consolidated Statements (Interco eliminations). [online] Available at: http://www.findmybestcpa.com/Accinfo/Consolidated-Statements-(Interco-eliminations)/161.html [Accessed 28 Mar. 2015].

Greuning, H. (2006).International financial reporting standards. Washington, D.C.: World Bank.

Holt, P. and Hein, C. (2001).International accounting. [Houston, TX]: Dame.

Hoyle, J., Schaefer, T. and Doupnik, T. (2007).Advanced accounting. Boston: McGraw-Hill Irwin.

Iasplus.com, (2011).IAS 28 — Investments in Associates and Joint Ventures (2011). [online] Available at: http://www.iasplus.com/en/standards/ias/ias28-2011 [Accessed 29 Mar. 2015].

Irs.gov, (n.d.).Sales and Trades of Investment Property. [online] Available at: http://www.irs.gov/publications/p550/ch04.html#en_US_publink100010540 [Accessed 27 Mar. 2015].

Novogradac, M. (2010).Renewable Energy Tax Credit Handbook.

Sec.gov, (n.d.).International Accounting Standards. [online] Available at: http://www.sec.gov/rules/concept/34-42430.htm [Accessed 29 Mar. 2015].

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