Lesson 51 - Intermediate Accounting Course 

51. Equity Method vs. Cost Method in Investment Accounting

When a company invests in another company, it must choose the appropriate accounting method to report the investment on its financial statements. The two primary methods are the Equity Method and the Cost Method (Fair Value Method under IFRS). The choice depends on the level of influence the investor has over the investee.

1️⃣ What Are the Equity Method and Cost Method?

A. Cost Method (Fair Value Method under IFRS) – Used for Passive Investments

✔ Used when the investor has little or no influence over the investee (typically owns less than 20% of the voting shares).
✔ The investment is recorded at its purchase cost on the balance sheet.
✔ Any dividends received are recorded as income on the income statement.
✔ The investment is not adjusted unless it is impaired or sold.

Example:
A company buys 5% of another company's stock for $10,000 and receives a $500 dividend.

Journal Entries:

Investment in XYZ Co.       $10,000  

      Cash                                  $10,000  

Cash                                      $500  

      Dividend Income                     $500  

B. Equity Method – Used for Significant Influence Investments

✔ Used when the investor has significant influence (typically 20-50% ownership).
✔ The investment is initially recorded at cost, but its value is adjusted based on the investee’s net income and dividends.
✔ The investor records a proportionate share of the investee’s net income or loss.
✔ Dividends reduce the investment balance instead of being recorded as income.

Example:
A company buys 30% of another company's stock for $50,000. The investee earns $20,000 in net income, and the investor's share is 30% of that ($6,000). The investee then pays a $2,000 dividend, and the investor’s share is $600.

Journal Entries:

Investment in XYZ Co.       $50,000  

      Cash                                  $50,000  

Investment in XYZ Co.       $6,000  (30% of $20,000 net income)  

      Investment Income                     $6,000  

Cash                                      $600  (30% of $2,000 dividend)  

      Investment in XYZ Co.                 $600  

2️⃣ Key Differences Between the Two Methods 

3️⃣ When to Use Each Method?

• Use the Cost Method (Fair Value Method) when you own less than 20% and have no control or significant influence over the investee.
  
  

• Use the Equity Method when you own between 20% and 50% and have significant influence over the investee’s operations.
  
  

If ownership exceeds 50%, the investor must use consolidation accounting, where the investee’s financials are combined with the investor’s financial statements.

4️⃣ Real-World Examples

✅ Apple’s Investment in Uber – Apple invested $1 billion in Uber but had no significant influence, so it used the Fair Value Method (Cost Method under GAAP).

✅ Berkshire Hathaway’s Investment in Coca-Cola – Warren Buffett’s company owns 9% of Coca-Cola but has no board seats or influence, so it uses the Fair Value Method.

✅ SoftBank’s Investment in WeWork – SoftBank had significant influence over WeWork before its takeover, so it used the Equity Method for accounting.

5️⃣ Key Takeaways

✔ The Cost Method is simpler and is used for passive investments (less than 20% ownership).
✔ The Equity Method requires adjustments for the investee’s net income and dividends (20-50% ownership).
✔ The choice of method affects financial statements, especially reported income and investment valuation.
✔ If ownership increases to more than 50%, the investor must consolidate the investee’s financials.