Question

1.When would the equity method be used to account for a long-term investment in stocks? (Be specific with respect to the percentage ownership.)

2 Consider your answer to the previous question. Why wouldn’t mark-to-market accounting be appropriate for such an investment? (Be specific.)

3    Reference the preceding questions. Why would the equity method never be appropriate for short-term investments in stocks? (Be specific.)

4 Briefly describe how an investment’s carrying value is determined if the equity method is being used.

Answer 1

1.The equity method tends to be most appropriate if an investment enables the investor to influence the operating or financial decisions of the investee.

Influence tends to be more effective as the investor's percent of ownership in the voting stock of the investee increases.

The equity method is only used when the investor can influence the operating or financial decisions of the investee. If there is no significant influence over the investee, otherwise investor uses the cost method to account for its investment.

Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset. The investor’s proportional share of the associate company’s net income increases the investment; a net loss, or proportional payment of dividends, decreases the investment. In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item.

Important Points

• Ownership between 20-50% is referred to as a minority interest in the organization, and must be reported using the equity method.
• In regards to control, minority interest is not a controlling position in the firm. In most situations, 51% ownership is required (majority).
• However, a minority interest stakeholder may be consulted on certain strategic decisions and may be on the board of directors.

2. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation based on current market conditions.

In trading and investing, certain securities, such as futures and mutual funds, are also marked to market to show the current market value of these investments.

Mark-to-market example: An investor purchases 100 shares in a company for $10 per share. The book value of their investment is $1,000. In the trading day following the purchase, the company’s stock price falls by 10%. The mark-to-market value is therefore $900. The book value remains $1,000.

3. the use of the equity method is no longer appropriate as the associate operates under severe long-term restrictions or short-term.

it ceases to have significant influence but retains either in part or in whole its investment.