Chapter 01 - The Equity Method of Accounting for Investments
CHAPTER 01THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS(QUESTIONS AT END OF FILE)
Three methods are principally used to account for an investment in equity securities alongwith a fair value option.
Fair-value method: applied by an investor when only a small percentage of acompany’s voting stock is held.1.Income is recognized when dividends are declared.2.Portfolios are reported at market value. If market values are unavailable,investment is reported at cost.
Consolidation: when one firm controls another (e.g., when a parent has a majorityinterest in the voting stock of a subsidiary or control through variable interests, their financial statements are consolidated and reported for the combined entity.
Equity method: applied when the investor has the ability to exercise significant influenceover operating and financial policies of the investee.
Ability to significantly influence investee is indicated by several factorsincluding representation on the board of directors, participation in policy-making,etc.
According to a guideline established by the Accounting Principles Board, theequity method is presumed to be applicable if 20 to 50 percent of the outstandingvoting stock of the investee is held by the investor.Current financial reporting standards allow firms to elect to use fair value for anyinvestment in equity shares including those where the equity method would otherwiseapply. However, the option, once taken is irrevocable. After 2008, can make the electionfor fair value treatment only upon acquisition of the equity shares. Dividends received andchanges in fair value over time are recognized as income.
Accounting for an investment: the equity method A.The investment account is adjusted by the investor to reflect all changes in theequity of the investee company.B.Income is accrued by the investor as soon as it is earned by the investee.C.Dividends declared by the investee create a reduction in the carrying amount of theInvestment account.