Prior to GAAP for equity method investments, firms often used the cost method to

Question

Prior to GAAP for equity method investments, firms often used the cost method to account for their unconsolidated investments in common stock regardless of the presence of significant influence. The cost method employed the cash basis of income recognition. When the investee declared a dividend, the investor recorded %u201Cdividend income.%u201D The investment account typically remained at its original cost %u2013 hence the term cost method.

Many firms%u2019 compensation plans reward managers based on reported annual income. How might the cost method of accounting for significant investments have resulted in unintended wealth transfers from owners to managers? Do the equity or fair-value methods provide similar incentives? Explain.

Explanation / Answer

If the controlling company had significant influence, managers of the controlling company could increase the income of the controlling company by transferring large dividends from the controlled company regardless of the income or perfomance of the controlled company. This would increase their compensation. Under equity or fair value methods the controlled company must actually have income for the controlling company to show gains and thus increase the income of the managers.

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.