Question

Tuue ul lhe investment account reduced under equity-method reporting? What is a differential? How is a differential treated by an investor in computing income from an investee under (a) cost-method and (b) equity-method reporting? Turner M U4-2 LO 4-1 Q4-3

Answer 1

• When one corporation buys the common stock of another, the purchase price normally is based on the market price of the shares acquired rather than the book values of the investee’s assets and liabilities. As a result, there often is a difference between the cost of the investment to the investor and the book value of the investor’s proportionate share of the underlying net assets of the investee. This difference is referred to as a differential. Differential net operating income compares the bottom line between both choices, in this case a $5,000 difference between Choice A and Choice B. Management uses this information as guidance in its quest to increase profits for the company.Differential accounting is only available to private companies. A private company is one that does not sell stock, bonds or other debt. Additionally, companies regulated by the government are not eligible to change their accounting method to differential. When a company chooses to report its finances using the differential accounting method, then it must change its records retroactively.

• Equity method, a company reports the carrying value of its investment independent of any fair value change in the market. With a significant influence over another company's operating and financial policies, the investor is basing its investment value on changes in the value of that company's net assets from operating and financial activities and the resulting performances, including earnings and losses. For example, when the investee company reports a net loss, the investor company records its share of the loss as "loss on investment" on the income statement, which also decreases the carrying value of the investment on the balance sheet.When the investee company pays a cash dividend, the value of its net assets decreases. Using the equity method, the investor company receiving the dividend records an increase to its cash balance but, meanwhile, reports a decrease in the carrying value of its investment. Other financial activities that affect the value of the investee's net assets should have the same impact on the value of the investor's share of investment. The equity method ensures proper reporting on the business situations for the investor and the investee, given the substantive economic relationship they have.

• When an investing entity makes an investment and the investment has the following two criteria, the investor accounts for the investment using the cost method.

1. The investor has no substantial influence over the investee (generally considered to be an investment of 20% or less of the shares of the investee).

2. The investment has no easily determinable fair value.

If there is evidence that the fair market value has increased above the historical cost, it is not allowable under Generally Accepted Accounting Principles to increase the recorded value of the investment. This is a highly conservative approach to recording investments.Under these circumstances, the cost method mandates that the investor account for the investment at its historical cost (i.e., the purchase price). This information appears as an asset on the balance sheet of the investor. Once the investor records the initial transaction, there is no need to adjust it, unless there is evidence that the fair market value of the investment has declined to below the recorded historical cost. If so, the investor writes down the recorded cost of the investment to its new fair market value.