The fair value method of equity, also known as the cost method, is an accounting approach used when a company holds a small percentage of ownership in another company. Specifically, it's applied when the investor owns less than 20% of the outstanding shares of the investee company.
Understanding the Fair Value Method
Under the fair value method, the investment is recorded at its initial cost. Here are the key characteristics:
- Initial Recording: The investment is recorded at the price paid to acquire the shares.
- Dividend Recognition: Dividends received from the investee are recognized as income.
- No Share of Profits or Losses: Unlike the equity method, the investor does not recognize their share of the investee’s profits or losses.
- Fair Value Adjustments: The investment's value on the investor's balance sheet is adjusted to fair value at the end of each reporting period. Changes in fair value are reflected in the income statement.
- No Significant Influence: This method applies when the investor does not have significant influence over the investee's operations.
Fair Value vs. Equity Method
It's crucial to distinguish the fair value method from the equity method. Here’s a comparison:
| Feature | Fair Value Method (Cost Method) | Equity Method |
|---|---|---|
| Ownership Percentage | Less than 20% | 20% to 50% |
| Recognition of Income | Dividends received | Share of Investee's Net Income |
| Investment Value Adjustment | To fair value each reporting period | Adjusted for share of income/losses |
| Influence | No significant influence | Significant influence |
| Investment on Balance Sheet | Reported at Fair Value | Reported at cost +/ - share of income/loss |
Example of Fair Value Method
Imagine Company A buys 5% of Company B's stock for $100,000.
- Initially, Company A records the investment at $100,000.
- If Company B pays a $5,000 dividend, Company A records this as dividend income.
- If at the end of the year, the fair value of Company B's stock is now $110,000, Company A will make an adjustment to increase the investment value to $110,000 on its balance sheet. The $10,000 difference is recorded as a gain on the income statement.
When to Use Fair Value Method
As outlined in the provided reference, the fair value method is used when:
- A company owns less than 20% of the outstanding shares of the investee company.
Why is this important?
The method is important because it impacts how the investor company's financial statements are presented, including their balance sheet and income statement. Correctly applying fair value method ensures accurate financial reporting.
