CHAPTER 1 THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS Chapter Outline I. Four methods are principally used to account for an investment in equity securities along with a fair value option. A. Fair value method: applied by an investor when only a small percentage of a company’s voting stock is held. 1. Income is recognized when the investee declares a dividend. 2. Portfolios are reported at fair value. If fair values are unavailable, investment is reported at cost. B. Cost Method: applied to investments without a readily determinable fair value. When the fair value of an investment in equity securities is not readily determinable, and the investment provides neither significant influence nor control, the investment may be measured at cost. The investment remains at cost unless 1. A demonstrable impairment occurs for the investment, or 2. An observable price change occurs for identical or similar investments of the same issuer. Income is typically recognized by the investor for its share of investee dividends declared. C. Consolidation: when one firm controls another (e.g., when a parent has a majority interest in the voting stock of a subsidiary or control through variable interests, their financial statements are consolidated and reported for the combined entity. D. Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee. 3. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc. 4. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares including those where the equity method would otherwise apply. However, the option, once taken, is irrevocable. Investee dividends and changes in fair value over time are recognized as income. II. Accounting for an investment: the equity method A. The investment account is adjusted by the investor to reflect all changes in the equity of the investee company. B. Income is accrued by the investor when it is reported in the investee’s financial statements. C. Dividends declared by the investee create a reduction in the carrying amount of the Investment account. This book assumes all investee dividends are declared and paid in the same reporting period.