What are the most common methods for valuing investments in Corporate Accounting?

1 Cost method

The cost method is a simple and conservative way of valuing investments that are not significant or influential to the investor. Under this method, the investment is recorded at its original cost and no adjustments are made for changes in fair value or dividends received. The only time the investment is revalued is when there is an impairment loss or a disposal. The cost method does not affect the income statement, but it reduces the cash flow from investing activities by the amount of the initial investment.

2 Fair value method

The fair value method is a more realistic and dynamic way of valuing investments that are not held for trading or classified as equity method investments. Under this method, the investment is recorded at its fair value at each reporting date and any changes in fair value are recognized in the income statement as unrealized gains or losses. Dividends received are also recorded as income. The fair value method affects both the income statement and the cash flow from investing activities, as the changes in fair value and the dividends received are added to or subtracted from the net income.

3 Equity method

The equity method is a sophisticated and complex way of valuing investments that give the investor significant influence over the investee. Under this method, the investment is recorded at its original cost and then adjusted for the investor's share of the investee's net income or loss, dividends paid, and other transactions. The investor's share of the investee's net income or loss is recorded as income or expense in the income statement, while the dividends paid are treated as a return of capital and reduce the carrying value of the investment. The equity method does not affect the cash flow from investing activities directly, but it affects the net income, which is a component of the cash flow from operating activities.

4 Net present value method

The net present value method is a discounted cash flow technique that is used to evaluate the profitability and feasibility of long-term investments, such as capital projects, acquisitions, or mergers. Under this method, the investment is valued by comparing the present value of its expected future cash inflows and outflows with its initial cost. The net present value is the difference between the two values and represents the excess or shortfall of the investment over its required rate of return. A positive net present value indicates that the investment is worthwhile, while a negative net present value indicates that the investment is not advisable. The net present value method affects the cash flow from investing activities by the amount of the initial investment and the subsequent cash inflows and outflows.

5 Internal rate of return method

The internal rate of return method is another discounted cash flow technique that is used to assess the attractiveness and efficiency of long-term investments. Under this method, the investment is valued by finding the discount rate that makes the present value of its expected future cash inflows and outflows equal to its initial cost. The internal rate of return is the discount rate and represents the annualized return of the investment. A higher internal rate of return implies a more desirable investment, while a lower internal rate of return implies a less favorable investment. The internal rate of return method affects the cash flow from investing activities by the amount of the initial investment and the subsequent cash inflows and outflows.