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. The investor recognizes income 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.
The investor typically recognizes its share of investee dividends declared as dividend
income.
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.
1. Ability to significantly influence investee is indicated by several factors including
representation on the board of directors, participation in policy-making, etc.
2. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the
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