Discussion: Did the Cost Method Invite Earnings Manipulation?
Discussion Requirements
Your original post is due by Day 4 by 11:59 PM Central Time. Your responses to at least three other original posts are due by Day 6 by 11:59 PM Central Time. Posts should take place on multiple calendar days throughout the week to generate conversation among students and the instructor. Posts are expected to be at least 150 words in length, well-written, APA formatted, meaningfully add to the conversation about the given topic, and incorporate material from the text and other sources into your original post and responses.
Original Post:
Prior to GAAP for equity method investments, firms often used the cost method to account for their unconsolidated investments in common stock regardless of the presence of significant influence. The cost method employed the cash basis of income recognition. When the investee declared a dividend, the investor recorded “dividend income.” The investment account typically remained at its original cost—hence the term cost method.
Many firms' compensation plans reward managers based on reported annual income. How might the use of the cost method of accounting for significant influence investments have resulted in unintended wealth transfers from owners to managers? Do the equity or fair-value methods provide similar incentives? Answer in complete sentences using proper APA citations as necessary. Reference your textbook and any outside sources you review to create this post.
Answer (1)
The cost method could invite earnings manipulation because firms using it recognize dividend income as profit, even if the investment's value has changed. This inflates reported income and can lead to manager bonuses tied to those inflated figures.In contrast, the equity method adjusts the investment account based on the investee's performance, giving a more accurate reflection of value. The fair-value method reflects market conditions but may also affect manager incentives. Both offer greater transparency than the cost method, reducing the chance of unearned performance rewards.
