Equity Method Of Accounting: Determine The Fundamental Reaso

Equity Method Of Accounting1 Determine The Fundamental Reasons Why Th

Determine the fundamental reasons why the Financial Accounting Standards Board (FASB) requires a company to use the equity method of accounting for investments. Next, propose two (2) theoretical problems of recognizing equity income that the opponents of the equity method would consider. Provide a rationale for your response. Analyze the potential impact of eliminating the retrospective application of the equity method to increases in previously held ownership interests that result in significant influence and which qualify for use of the equity method. In the role of the chief executive officer (CEO) for a midsized company, propose the type of managerial incentives that could influence the company’s percentage ownership in another company. Provide a rationale for your response.

Paper For Above instruction

The equity method of accounting is a vital component in financial reporting, particularly when a company holds significant influence over its investee, typically recognized through ownership interests of 20% to 50%. The Financial Accounting Standards Board (FASB) mandates the use of the equity method to ensure that investments' financial impacts are accurately reflected in the investor’s financial statements. This paper explores the fundamental reasons behind this requirement, potential criticisms from opponents, and managerial incentives influencing ownership percentages.

Fundamental Reasons for the Equity Method Requirement

The primary rationale behind FASB's requirement for the equity method revolves around accurately representing an investor’s economic interest and influence over an investee. Unlike the cost method, which records investments at cost and recognizes income only when dividends are received, the equity method integrates the investor’s share of the investee’s net income or loss, reflecting a more authentic picture of economic ties and performance. This method aligns with the principle of relevance by providing stakeholders with timely and pertinent information about the investee’s financial health and how it impacts the investor’s financial position (Bauman, 2019).

Another fundamental reason is the concept of control and influence. When an investor has significant influence, usually evidenced by board representation or voting rights, the investment is expected to affect the investor’s future cash flows and financial decisions. Using the equity method ensures that these influences are duly recognized, thus avoiding the understatement or overstatement of the investment's value, which might occur under other methods like cost or fair value (FASB, 2018).

Theoretical Problems of Recognizing Equity Income

Despite its advantages, opponents raise critical theoretical concerns regarding the recognition of equity income under this method. The first problem involves the potential for income smoothing. Since the investor recognizes a proportionate share of the investee’s net income, there exists an incentive—and possibility—for management to manipulate or time earnings to enhance the perceived profitability, thereby affecting reported income artificially. This transparency issue can mislead stakeholders and distort the true financial performance (Jones & Roberts, 2020).

The second problem concerns the attribution of income when there are significant differences in accounting policies or valuation methods between the investor and investee. Opponents argue that recognizing equity income might involve assumptions or estimates that do not accurately reflect the economic reality, especially if the investee’s earnings are abnormal, volatile, or influenced by non-recurring items. Such discrepancies can lead to inconsistent or misleading financial reporting (Khan & Werther, 2017).

Impact of Eliminating Retrospective Application of the Equity Method

The retrospective application of the equity method requires restating prior periods’ financial statements to reflect increases in ownership interests that lead to significant influence. Eliminating this requirement could have notable impacts, including reduced comparability across reporting periods and diminished accuracy of historical financial information.

Without retrospective adjustment, investors and analysts might struggle to accurately assess trends and performance over time, as changes in ownership interests will only be reflected prospectively. This could obscure understanding of the influence the investor has had historically, potentially resulting in misinformed investment decisions (Pettit & Ferguson, 2021). Conversely, proponents argue that retrospective application can introduce complexities and delays in financial reporting, negatively affecting the timeliness of information dissemination.

Managerial Incentives and Ownership Percentages

As a CEO of a midsized company, managerial incentives play a crucial role in influencing ownership percentages in other companies. One common incentive involves strategic control; increasing ownership might secure a greater influence over the investee’s strategic decisions, leading to better integration of the subsidiary’s operations with the parent’s objectives. Another incentive could be financial; acquiring larger ownership stakes often means higher potential returns through dividends, increased share value, or eventual control transfer, aligning management’s interests with shareholder wealth maximization (Caprio & Levine, 2020).

Furthermore, managers may be incentivized by performance-based compensation tied to the success of the investment or the strategic goals achieved through increased ownership. This can include bonuses, stock options, or other pay-performance linkages. Such incentives motivate managers to pursue higher ownership stakes to maximize both personal and corporate value (Gordon & Korn, 2016).

Conclusion

The equity method of accounting serves an essential function in reflecting economic influence and providing relevant financial information. While its implementation has been met with criticism regarding income recognition and consistency, it remains fundamental in portraying investments with significant influence accurately. Managerial incentives can significantly influence ownership strategies, impacting corporate governance and financial reporting. Ultimately, both regulatory standards and managerial motivations drive the application and implications of the equity method in contemporary financial practice.

References

• Bauman, P. (2019). Financial accounting and reporting. Wiley.
• Capital & Levine, S. (2020). Corporate governance and management incentives. Harvard Business Review.
• FASB. (2018). Accounting standards update: Investment accounting and reporting. Financial Accounting Standards Board.
• Gordon, R. A., & Korn, H. (2016). Incentives for corporate ownership and control. Journal of Accounting and Economics, 62(2-3), 404-426.
• Jones, M. J., & Roberts, P. (2020). The impact of earnings management and income smoothing practices. Accounting Horizons, 34(4), 113-129.
• Khan, A., & Werther, W. B. (2017). Ethical dilemmas in financial reporting. Journal of Business Ethics, 144(2), 343-351.
• Pettit, J., & Ferguson, R. (2021). Financial reporting standards: Retrospective vs. prospective application. The Accounting Review, 96(1), 45-67.
• FASB. (2018). Accounting standards update: Investment accounting and reporting. Financial Accounting Standards Board.
• Jones, M. J., & Roberts, P. (2020). The impact of earnings management and income smoothing practices. Accounting Horizons, 34(4), 113-129.
• Khan, A., & Werther, W. B. (2017). Ethical dilemmas in financial reporting. Journal of Business Ethics, 144(2), 343-351.