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Fair Value vs. Equity Method Explained

The document discusses the differences between the fair value method and equity method for accounting for business investments. The fair value method records investments at fair value with changes impacting net income, while the equity method adjusts the investment for the investor's share of earnings or losses of the investee.

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shakira22002
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13 views1 page

Fair Value vs. Equity Method Explained

The document discusses the differences between the fair value method and equity method for accounting for business investments. The fair value method records investments at fair value with changes impacting net income, while the equity method adjusts the investment for the investor's share of earnings or losses of the investee.

Uploaded by

shakira22002
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Business process flows for investment transactions differ significantly depending on whether the

fair value method or the equity method is used. Here's an explanation of the key differences:

​ Fair Value Method:


● Under the fair value method, investments are initially recorded at cost, but they are
subsequently adjusted to reflect their fair value in the financial statements.
● Fair value adjustments are typically recorded in the income statement. Therefore,
changes in the fair value of investments impact the net income of the investor.
● The fair value method does not involve significant influence or control over the
investee company.
● When transactions occur under the fair value method, the process involves periodic
revaluation of the investments to their current market value, which requires ongoing
monitoring and assessment.
● In terms of accounting entries, any unrealized gains or losses resulting from changes
in fair value are recognized in the income statement.
​ Equity Method:
● Under the equity method, the investor initially records the investment at cost.
Subsequently, the investor adjusts the investment account to reflect its share of the
investee's earnings or losses.
● The equity method is typically used when the investor has significant influence over
the investee but does not control it outright. Significant influence usually implies
ownership of 20-50% of the investee's voting shares.
● When transactions occur under the equity method, the investor records its
proportionate share of the investee's net income or loss in its own income statement.
Additionally, dividends received from the investee are treated as a reduction of the
investment's carrying amount.
● Unlike the fair value method, under the equity method, changes in the fair value of the
investment do not directly impact the income statement. Instead, they are reflected
in the carrying amount of the investment on the balance sheet.
● If the investee pays dividends, the investor recognizes its share of those dividends as
income, reducing the carrying value of the investment.

In summary, the key differences lie in how investments are initially recorded, subsequent

adjustments, the treatment of changes in fair value, and the impact on the income statement. The

fair value method focuses on marking investments to market and recognizing unrealized gains or

losses in the income statement, while the equity method emphasizes reflecting the investor's share

of the investee's earnings or losses on an ongoing basis.

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