Question

Although the equity method is a generally accepted accounting principle (GAAP), recognition of equity income has many critics. For this discussion, use your knowledge of the equity method of accounting for investments to complete the following:

What problems could opponents of the equity method identify? Note that some research may be necessary to answer this question.

Which managerial incentives could influence a firm's percentage ownership interest in another firm?

Answer 1

Answer:

The equity method has been criticized because it allows the investor to recognize income that may not be received in any usable form during the foreseeable future. Income is being accrued based on the investee's reported earnings not on the dividends collected by the investor. Frequently, equity income will exceed the cash dividends received by the investor with no assurance that the difference will ever be forthcoming.

Many companies have contractual provisions (e.g., debt covenants, managerial compensation agreements) based on ratios in the main body of the financial statements. Relative to consolidation, a firm employing the equity method will report smaller values for assets and liabilities. Consequently, higher rates of return for its assets and sales, as well as lower debt-to-equity ratios may result. Meeting the provisions of such contracts may provide managers strong incentives to maintain technical eligibility to use the equity method rather than full consolidation.