Question

• Determine the fundamental reasons why 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 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.

Answer 1

Equity method is an bookkeeping method used by companies to measure the incomes that is earned by capitalizing in other companies. The firm reports the revenue received on the investment on its income statement and the stated value is founded on the firm's share of the company assets. The return that is received should be relative to the size of the equity investment. This is a method that is constantly used where one enterprise has noteworthy effect over another for example higher voting power and policy making decisions.

Reasons for using equity method.

· Profits are intermittently adjusted to replicate the changes in worth due to the investor's share in the company's income or losses.

· The method is suitable in accounting the fraction possession of another firm.

· Income calculation is simple from the time when the base used is the amount of investment in that specific company. Eg.,, if a firm owns 25% of another firm and the stated incomes is $1 million, then the parent firm would take an income of $250,000

· It can effortlessly portray how well does the specific firm executes and if the investment is commendable it or not. It therefore notifies the management to make the right investment decisions

Theoretical problems of Equity Method.

· The technique does not evidently state nor deliver a clear advice on how to account for deferred tax or how to regulate goodwill on acquirement.

· The technique would only apply to one category that is the subsidiaries which would convey inequality when account for associates and joint ventures.

· Whenever there is variations say from subsidiary to associate, it would be problematic for the investor to change the accounting to make it steady with other subsidiaries.

Proposed managerial incentives

· Paying the managers conditional on their enactment of projects undertaken. This will permit managers to take on contracts that are only lucrative and produces best output.

· Inspiring the managers by paying them well to evade the effects of agency costs arising. This would therefore safeguard that the managers deliberates the shareholders’ interests.

· Giving the managers bonuses in addition to their basic salaries to keep them working extra hard to yield the needed to consequences to earn them more extras.

· Offering the managers an opportunity to buy shares and rights of the firm at discount prices in order to provoke them come up with projects which increases profitability of the firm.