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Understanding the financial reporting consequences for: A change to the equity method.
EQUITY VERSUS FAIR-MARKET-VALUE METHOD FOR THE CARRYING VALUE OF INVESTMENTS IN COMMON STOCK: A RESEARCH NOTE
By; Richard A. Bernardi, Roger Williams University
Megan D. Williams, Roger Williams University
Background
The equity method is used primarily to evaluate profits received by their investment in other companies (FASB.org).
The major deciding factor on whether to purchase more than 20% of the investee’s common stock is impacted
by how the investee reports profits and losses (FASB.org).
The study examined whether the fair market-value or equity method of accounting for investments provides
a higher value for the financial statements of the investor (Bernardi, 2016).
Income is accrued based on reported earnings and not the share of dividends and are recorded as decreases to the
Investment account and not as income (FASB.org).
Sample Size
The following sample includes 517 companies from the Value Line Investment Survey (2006, 2007).
The data collected include market values at December 31, 2000, which was the base year and data for calendar years 2001 through 2005 that includes:
* earnings per share
* dividends per share
* stock splits/stock dividends.
The authors used earnings per share because it allowed them to work around the 20 percent requirement for influence,which is required to use the equity method and would vary amongst the 517 firms in the sample (Bernardi, 2016).
| TABLE 1 | |||
| Sample by Industry and Percent of Industry | |||
| Industry | Total | Sample | Percent |
| Advertising | 8 | 5 | 62.5 |
| Aerospace/Defense | 20 | 7 | 35.0 |
| Air Transport | 10 | 6 | 60.0 |
| Apparel | 14 | 8 | 57.1 |
| Auto & truck | 11 | 5 | 45.5 |
| Auto Parts | 18 | 1 | 5.6 |
| Basic Chemical | 8 | 4 | 50.0 |
| Beverage | 13 | 13 | 100.0 |
| Biotech | 17 | 4 | 23.5 |
| Building Materials | 96 | 9 | 9.4 |
| Cement & Aggrates | 12 | 5 | 41.7 |
| Chemical (Special) | 32 | 2 | 6.3 |
| Computer & Peripherals | 27 | 16 | 59.3 |
| Diversified | 37 | 17 | 45.9 |
| Drug Industry | 44 | 25 | 56.8 |
| Electric Utilities (Comb) | 69 | 35 | 50.7 |
| Electrical Equip | 20 | 11 | 55.0 |
| Electronics | 25 | 14 | 56.0 |
| Entertainment | 15 | 6 | 40.0 |
| Environmental | 8 | 3 | 37.5 |
| Food processing | 32 | 16 | 50.0 |
| Food wholesale | 5 | 5 | 100.0 |
| Home Furnish | 74 | 7 | 9.5 |
| General Steel | 10 | 6 | 60.0 |
| Grocery Store | 13 | 8 | 61.5 |
| Home Appliance | 6 | 4 | 66.7 |
| Home Building | 98 | 7 | 7.1 |
| Hotel/ Gaming | 14 | 4 | 28.6 |
| Household Prod | 61 | 10 | 16.4 |
| Human Resources | 11 | 6 | 54.5 |
| Industrial Services | 27 | 12 | 44.4 |
| Inform Services | 44 | 2 | 4.5 |
| Machinery | 40 | 18 | 45.0 |
| Maritime | 8 | 2 | 25.0 |
| Medical Supplies | 60 | 11 | 18.3 |
| Table 1 (continued) | |||
| Metal Fabricating | 9 | 5 | 55.6 |
| Mining and Metal | 12 | 1 | 8.3 |
| Newspaper | 12 | 5 | 41.7 |
| Office supplies | 12 | 6 | 50.0 |
| Package & Contain | 57 | 13 | 22.8 |
| Paper/Forest Prod | 51 | 5 | 9.8 |
| Petroleum (Integrated) | 20 | 3 | 15.0 |
| Pharmacy Services | 9 | 2 | 22.2 |
| Power | 62 | 7 | 11.3 |
| Precious Metals | 10 | 1 | 10.0 |
| Precision Instruments | 29 | 22 | 75.9 |
| Publishing | 13 | 5 | 38.5 |
| Railroad | 7 | 2 | 28.6 |
| Recreation | 18 | 10 | 55.6 |
| Restaurant | 20 | 9 | 45.0 |
| Retail Auto | 8 | 3 | 37.5 |
| Retail Build Sup | 80 | 6 | 7.5 |
| Retail Store | 19 | 10 | 5.3 |
| Semiconductor | 39 | 26 | 66.7 |
| Shipping | 21 | 2 | 9.5 |
| Shoe | 11 | 4 | 36.4 |
| Specialty line Retail | 86 | 25 | 29.1 |
| Steel (integrated) | 5 | 1 | 20.0 |
| Tobacco | 6 | 4 | 66.7 |
| Telecom Services | 17 | 11 | 64.7 |
| Telecom Equip | 21 | 3 | 14.3 |
| Tire & Rubber | 4 | 1 | 25.0 |
| Toiletries/Cosmetics | 11 | 1 | 9.1 |
| Wireless Network | 14 | 10 | 71.4 |
| Totals | 1,690 | 517 | 30.6 |
(Bernardi, 2016).
Analysis
The market value on the last trading day of 2000 was used, and the closing price in 2005. Equity method values were calculated using the 2000 closing price, minus any cash dividends, plus the earnings.
The difference between the two ending values was then calculated.
Each company’s gains or losses for the five-year period were computed using each fair-market-value and the equity method of accounting for investments in other corporations (Bernardi, 2016).
Valuation differences
The value of each method was first examined over the entire five-year period of this research. For the fair-market-value method, the investment account was adjusted annually for its market value.
However, for the equity method, the value of the investment was reduced by the amount of dividends per share and increased by the amount of earnings per share (Bernardi, 2016).
The primary result was that there are indications suggesting that the equity method is a more conservative method.
The differences apparent between the two methods suggest that the equity method does not anticipate future earnings (Bernardi, 2016).
Wrapping Up
A change to equity method may not mean a huge impact to the investor’s financial reports.
A company should only change to the equity method when: The investment previously recorded using the cost or
fair-value method reaches a point where significant influence is established.
If an investment meets the requirement for use of the equity method, the investor adds the cost of obtaining the
additional interest in the investee to the current basis (Carpenter, 2017).
It is also important to note that variations in the element of the investor-investee relation between passive and
nonpassive investments are based on relative timing and not fixation on accounting revenue recognition events”
(Graham, 2019).
REFERENCES
Bernardi, R. A., & Williams, M. (2016, December 27). Equity Versus Fair Market Value Method for the Carrying Value
of Investments in Common Stock: A Research Note. SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2890228.
Carpenter, B. W., & Mahoney, D. P. (2017, May 25). Applying the Equity Method under ASU 2016-07.
https://www.cpajournal.com/2017/02/14/applying-the-equity-method-under-asu-2016-07-another-milestone
-in-fasbs-simplification-initiative/.
Financial Accounting Standards Board, Investments--Equity Method and Joint Ventures (Topic 323): Simplifying
the transition to the equity method of accounting. (2016). Norwalk, CT.
Graham, R. C., & Lefanowicz, C. E. Evidence of the Relation between Accounting for Equity Investments and
Equity Valuation. Journal of Accounting, Auditing & Finance, 11(4), 587–605. https://doi.org/10.1177/0148558x9601100404
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