Question

Explain why accounting for investments in other companies on the cost method might allow managers to manipulate income, or to hide losses. What is meant by significant influence and control under GAAP?

Answer 1

Cost method of investment is one of the traditional method of accountingit is used generally when the investor have less than 20% control in the investee. These method allows managers to manipulate income or to hide loss the reasons of these are as follows:-

The cost method does records gain only whent it is realized it means if it earn and not realize it will not be recorded so similarly it is  applicable in case of loss so managers try to take advantage of the situation in hiding a loss.

Another reason is this method does not record the actual flutation in the assets so it will does not report the actuall scenarios going on in the market. through these managers try to show the investors all is going fine but actually it is not.

Significance influence means when an entity is eligible to take participate in the policies and decisson making activities of the investee entity it is obtained when an investor purchase 20% or more than 20% but less than 50% common stocks. control means ability of the investor to diret the policies of the investee. it is obtained by purchasing more than 50% common stock of the investee.