Question

Explain the difference between the cost method, the equity method, and the fair value method. Provide examples to support your explanations.

Answer 1

POINT - I

Cost method:

Cost Method Accounting is an accounting method in which the assets listed on a company's financial statements are recorded based on the price at which the assets were purchased.

  

Fair Value Method:

Fair Value Method accounting records the current market price of an asset or liability on companies' financial statements

Equity Method:

The equity method is a type of accounting used in investments. This method is used when the investor holds significant influence over investee, but does not exercise full control over it, as in the relationship between parent and subsidiary.

POINT – II

Cost method:

Under generally accepted accounting principles (GAAP) in the United States, the historical cost principle accounts for the assets on a company's balance sheet based on the amount of capital spent to buy the asset.

Fair Value Method:

Fair value accounting is a financial accounting approach that companies use to report their assets and liabilities at estimated prices, which they would receive if they were to sell the assets or the liabilities they would pay if they were to be alleviated of their liabilities.

Equity Method:

The investor will report a proportionate share of the investee’s equity as an investment (at cost). Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. This is known as the “equity pick-up”. Dividends paid out by the investee are deducted from this account.

POINT – III

Cost method:

This method is based on a company's past transactions and is conservative, easier to calculate and reliable.

Fair Value Method:

Mark-to-market accounting aims to make financial accounting information more accurate and relevant. However, this can be a problem is market prices fluctuate a great deal.

Equity Method:

Under the equity method, the investor begins as a baseline with the cost of its original investment in the investee, and then in subsequent periods recognizes its share of the earnings or losses of the investee, both as adjustments to its original investment as noted on its balance sheet, and also in the investor’s income statement.

POINT – IV

Cost method:

For example, suppose company ABC bought multiple properties in New York City 100 years ago for $50,000. Under historical accounting, the cost of the properties recorded on the balance sheet is $50,000.

Fair Value Method:

For example, suppose company ABC bought multiple properties in New York City 100 years ago for $50,000. Under historical accounting, the cost of the properties recorded on the balance sheet is $50,000. However, a real estate appraiser inspects all of the properties and concludes that the expected market value is $50 million. Under market-to-market, or fair value, accounting, the assets are recorded as $50 million on its balance sheet.

Equity Method:

ABC International acquires a 30% interest in Blue Widgets Corporation. In the most recent reporting period, Blue Widgets recognizes $1,000,000 of net income. Under the requirements of the equity method, ABC records $300,000 of this net income amount as earnings on its investment (as reported on the ABC income statement), which also increases the amount of its investment (as reported on the ABC balance sheet).