Question

Assume that Big Company owns 40% of the stock of Little. Big is the largest shareholder of Little. Little is not a publicly traded company, and there is no easy way to know the fair value of its stock. Explain why using the equity method of accounting for this investment provides financial statement users with better information than the cost method would. I am looking for two or more ways in which the equity method gives information that better reflects either income or the value of the investment, or both, than the cost method.

Answer 1

The equity method is an accounting technique used by a company to record the profits earned through its investment in another company. With the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement, in an amount proportional to the percentage of its equity investment in the other company.

Under the equity method, the investment is initially recorded at historical cost and adjustments are made to the value based on the investor's percentage ownership in net income, loss, and dividend payouts.

The equity method acknowledges the substantive economic relationship between two entities.

Under the cost method, the stock purchased is recorded on a balance sheet as a non-current asset at the historical purchase price, and is not modified unless shares are sold, or additional shares are purchased. Any dividends received are recorded as income, and can be taxed as such.

So Using Equity method for investment show true value of investment and reduces the tax of the investor as dividend received is adjusted with value of investment and not shown in profit and loss account.