Cost Method

The Cost Method is a straightforward accounting rule used when a company makes an investment in another company but doesn't have much say in how it's run. Think of it as being a silent partner. Typically, this applies when the investor owns less than 20% of the other company's voting stock, meaning it lacks 'significant influence.' Under this method, the investment is recorded on the investor's balance sheet at its original purchase price—the historical cost. This value stays put and doesn't change, regardless of whether the investee company is hitting home runs or striking out. The only time the investor recognizes any income from this holding is when the investee company pays out dividends. These dividends are then reported as dividend income on the investor's income statement. It’s a simple, no-fuss approach, but as we'll see, its simplicity can sometimes hide a more interesting story.

The mechanics of the cost method are simple, which is both a blessing and a curse. Here’s the breakdown:

• Initial Purchase: When Company A buys a stake in Company B, the investment is recorded on Company A's balance sheet at exactly what it paid. If they paid $1 million for the shares, the asset “Investment in Company B” is valued at $1 million.
• Performance of the Investee: If Company B has a wildly profitable year, its value might double. However, on Company A's books, the investment value remains stuck at the original $1 million. The investee's profits and losses are ignored in the day-to-day accounting.
• Receiving Dividends: This is the only time the investment generates income for the investor's income statement. If Company B pays a dividend, Company A records its proportional share as income.
• Selling the Investment: If Company A sells its stake for $1.5 million, it will then recognize a $500,000 gain ($1.5M sale price - $1M cost).
• The Exception: Impairment: The only other time the value changes is if something goes very wrong. If the investment's value is deemed to have permanently dropped below its cost (e.g., the investee is facing bankruptcy), the investor must write down the asset and recognize an impairment loss.

For a value investor, the cost method is a classic case of accounting reality differing from economic reality. This is where you can find hidden gems.

The biggest drawback of the cost method is that it can dramatically understate the true value of an investor's assets. Imagine a company like Coca-Cola in its early days, reinvesting every penny of profit to fund its global expansion. An early investor using the cost method would show only their tiny initial investment on their books for years. Meanwhile, the economic value of their stake would be skyrocketing. This creates a “hidden asset” on the balance sheet, one that is not reflected in the book value.

This is where Warren Buffett’s wisdom shines. He urges investors to look past the accounting and calculate look-through earnings. Instead of just counting the dividends Berkshire Hathaway receives, he mentally adds Berkshire's proportional share of the undistributed earnings from all its investments. If Berkshire owns 10% of a company that earns $1 billion and retains it all, Buffett considers Berkshire to be $100 million richer, even if accountants can't report it that way. This is the true measure of the yearly economic gain. As an investor, your job is to be a detective. When analyzing a company, dig into the notes of its financial statements. Find the investments accounted for under the cost method and assess their true earning power. You might just discover a treasure chest of value that the market has overlooked.

Understanding the difference between the cost method and its cousin, the equity method, is key.

• When to Use:
  1. Cost Method: For passive investments with no significant influence (typically < 20% ownership).
  2. Equity Method: For investments with significant influence (typically 20-50% ownership).
• Balance Sheet Impact:
  1. Cost Method: Investment is held at its original cost, unless impaired.
  2. Equity Method: Investment value is adjusted up or down each year by the investor's share of the investee's profits or losses, and reduced by dividends received.
• Income Statement Impact:
  1. Cost Method: Income is only recognized when dividends are received.
  2. Equity Method: Investor reports its proportional share of the investee's net income as its own income, regardless of whether dividends are paid.

Let's say FunCorp decides to invest in a promising startup, Innovate Inc. On January 1st, FunCorp buys 15% of Innovate Inc. for $300,000. FunCorp's balance sheet now shows an asset, “Investment in Innovate Inc.,” for $300,000. During the year, Innovate Inc. has a blockbuster year, earning $200,000 in profit. It decides to reinvest all of it back into the business and pays no dividend. Result under the Cost Method: Nothing changes on FunCorp's books. The investment still sits at $300,000, and no income is reported. However, the economic reality is that FunCorp's stake in Innovate Inc. is now backed by more value, specifically its share of the profits ($200,000 x 15% = $30,000). This value is real, but it remains hidden from the financial statements until FunCorp either sells its stake or Innovate Inc. starts paying dividends.