Investing in a publicly traded corporation by buying stock is among the fundamental investment options open to individuals at many different income levels. However, the amount of stock in a company that an individual buys can determine not only how much that investor stands to profit from the business's growth, but also how the stockholder needs to account for the investment.
Using Cost Method
Cost method accounting is a relatively straightforward method for recording the money an investor spends to buy stock in a company. Under cost method accounting, the investor lists the actual cost of the stock as an investment expense on a single line of a ledger or investment balance sheet. Upon selling the stock, the investor would list the income as a single line of revenue. Cost method accounting is appropriate for most investors who purchase less than 20 percent of the shares in a given company.
Equity Method Cases
Some investors purchase more than 20 percent of a company's shares of stock, which generally makes it more useful to use the equity method of accounting. The equity method of accounting takes the investor's influence over the company into consideration. For example, an investor who owns 25 percent of all shares may personally control several seats on the corporate board of directors. Large investors also have influence over business decisions. Equity accounting allows an investor to frequently update the value of an investment account based on changes in the company's performance.
Although both cost method accounting and equity method accounting seek to keep track of the same basic financial information about an investment, they treat stock dividends very differently. Under cost method accounting, dividends appear as income on the investor's books, with each share of stock generating a predetermined cash dividend. In equity accounting, dividends actually reduce the investment account, due to the cost of issuing a dividend. In this sense, major stockholders are aligned with corporate leaders, who view dividends as expenses under equity accounting.
Selecting a Method
The 20 percent ownership threshold is sufficient to help most investors determine which accounting method to use for their investments. Cost accounting is a much simpler process, but may not provide a clear or complete financial picture for large-scale investors whose investments gain and lose value due to factors beyond changes in stock price. For investors who own more than 50 percent of a company, it may be necessary to produce even more complex financial statements to augment equity accounting.