Equity and Cost Methods in Accounting - Essay Example

Finance and Accounting of Finance and Accounting a. Equity Method General Journal GENERAL JOURNAL Date Account Titles and Explanation DebitCreditP. R.1.1.11 Investment in Investee 150,000   Cash  150,000  To record investment in Investee Corporation   31.5.11 Cash 12,000   Investment in Investee  12,000  To record Dividend declared and paid   31.12.11 Investment in Investee 20,000   Investment income  20,000  To record proportionate share of new income   1.10.12 Cash 8,000   Investment in Investee  8,000  To record Dividend declared and paid   31.12.12 Investment in Investee 16,000   Investment income  16,000  To record proportionate share of new income   1.1.13 Cash 178,000   Investment in Investee  166,000  Gain from Equity  12,000  To record sale of Investee Corporation shares held         b.

Cost MethodNameGeneral JournalGENERAL JOURNAL Date Account Titles and Explanation DebitCreditP. R.1.1.11 Investment in Investee 150,000   Cash  150,000  To record Investment in Investee Corporation         31.5.11 Dividend Receivable 12,000   Investment income  12,000  To record Dividend declared     Cash 12,000   Dividend Receivable  12,000  To record Dividend paid   1.10.12 Dividend Receivable 8,000   Investment income  8,000  To record Dividend declared     Cash 8,000   Dividend Receivable  8,000  To record Dividend paid   1.1.13 Cash 178,000   Investment in Investee  150,000  Gain from Equity  28,000c.

Each of the two methods will give a different value for the investment. That is because of the adjustments that need to be applied to the initial investment due to transactions involving dividends and income of the investee. Under the equity method, one adjusts the investment by the investor’s share of income or loss. One also has to subtract Dividends, as they are returns on investment. That gives the investment a new value. Under the cost method, the value of the investment remains constant, as the dividends and income do not affect that value.

Accounting principles treat Dividend as revenue and hence it should not be subtracted from the initial value of the investment. The cost method, therefore, shows a bigger value for the investment than the equity method.Since dividends under the cost method are a form of revenue, they create taxable income. For example, if the Investee Corporation pays out $1.50 per share in dividends in 2011, Investor Corporation’s income is $12,000. In the 25 percent tax bracket, its tax liability would be $4,000.

The equity method affects income greatly and hence has an effect on income taxes. Suppose Investee Corporation records income of $100,000 in 2011. Investor Corporation would record income of $20,000. The tax liability would $5,000. Income is more volatile than the dividend yield hence the equity method is more likely to affect the Investor Corporations tax liability.Since earnings of the investee corporation keep changing from year to year, it would be recommendable that the Investor Corporation should use the fair value method.

That would help it avoid reporting the share of the investee’s earnings and losses that it bears. The changes in earnings of the Investee over the years will, therefore, have little effect on the value of the investment over time.ReferencesBline, D. M., Fischer, M. L., and Skekel, T. D. (2004). Advanced Accounting. New Jersey: WileyCarmichael, D. R. and Lynford, G. (2010). Accountants Handbook (Accountants Handbook Supplement) 11th Edition. New Jersey: WileyChristensen, T., Cottrell, D. and Baker R. (2013). Advanced Financial Accounting Tenth Edition.

New York: McGraw-Hill Jeter, D. C. and Chaney, P. (2007). Advanced Accounting. New Jersey: Wiley