Cost method

Definition

The cost method is an accounting approach used to record the acquisition of an investment in stock at its purchase price, without considering changes in market value. This method reflects the actual cost incurred to acquire the shares, which is essential when analyzing and recording transactions for stock issuance and repurchase. It focuses on the historical cost principle, ensuring that the financial statements reflect the true amount spent on the investment rather than any speculative or fluctuating market values.

5 Must Know Facts For Your Next Test

1. Under the cost method, stocks are recorded at their historical cost, which includes any related fees or commissions incurred during the purchase.
2. The cost method does not adjust the carrying value of the investment for changes in market price, meaning unrealized gains or losses are not reflected in financial statements.
3. When stock is repurchased, if it’s done at a price different from its original cost, this can affect how treasury stock is recorded under the cost method.
4. Dividends received from investments recorded using the cost method do not affect the carrying amount of the investment but are recorded as income.
5. If a company sells its stock investment at a profit or loss, that difference is recognized as a gain or loss in the income statement, but only upon sale.

Review Questions

• How does the cost method impact the recording of treasury stock transactions?
  • When treasury stock is repurchased using the cost method, it is recorded at the purchase price regardless of its original issuance price. This means that if a company buys back shares at a higher or lower price than they were originally sold, the difference does not affect the original paid-in capital. The treasury stock account reflects this purchase as a contra equity account on the balance sheet, which reduces total equity.
• In what way does the cost method differ from fair value accounting when reporting investments in stocks?
  • The cost method records investments based on historical acquisition costs and does not adjust for market fluctuations, while fair value accounting would reflect current market values of those investments. This difference affects how gains and losses are reported; under fair value accounting, unrealized gains or losses are included in earnings or other comprehensive income. In contrast, with the cost method, these gains or losses are only recognized when the investment is actually sold.
• Evaluate how using the cost method influences financial analysis and decision-making for investors considering stock investments.
  • Using the cost method provides investors with a clear view of how much was initially invested in stocks without being swayed by fluctuating market values. This focus on historical cost can simplify decision-making by reducing complexities tied to market volatility. However, it may also lead to misinterpretations regarding current investment performance since unrealized gains and losses aren't reflected until realized through sale, which could impact strategic decisions on whether to hold or sell investments based on perceived market conditions.

Related terms

par value: The nominal or face value of a stock as stated in the corporate charter, often used in determining the minimum amount that must be paid for shares.

additional paid-in capital: The amount received from shareholders above the par value of the stock, representing funds raised by a company through issuing shares.

dividend: A portion of a company's earnings distributed to shareholders, which can impact the overall return on investment for stockholders.