What is the difference between the fair value method and the equity method? - Universal CPA Review (2024)

FAQs

What is the difference between the fair value method and the equity method? - Universal CPA Review? ›

Answer and Explanation:

Under fair value method: • The cash dividends received from the investee is reported as revenue (not the investee's profit). The investor has no/little influence over the distribution of the investee's net income. Under equity method: • The investor reports as revenue its share of the investee's net income.

Under the equity method, the investment is recorded as an asset on the balance sheet based on the acquired cost (price paid). Subsequent to the initial recording, the investment balance increases when the investment reports net income, and decreases for any net losses or dividends paid by the investment.

If the company owns less than 20% of the outstanding shares for the company they invested in, then the fair value method (i.e., cost method) is used. If the company owns between 20% to 50% of the outstanding shares, then the equity method is used.

The main difference is that the equity method is used when ownership is between 20% and 50%. As soon as the company has 50% ownership or more, the investment needs to be accounted for under the acquisition (aka consolidation) method since the company has majority ownership.

The buyer sets a specific price based solely on the true value of the item, and the buyer freely agrees to pay the listed price in return for the product. For example, if an appraiser priced a 50-year-old trading card at $500, then the consumer could willingly agree to purchase it for that price because it is fair.

Equity value, commonly referred to as the market value of equity or market capitalization, can be defined as the total value of the company that is attributable to equity investors. It is calculated by multiplying a company's share price by its number of shares outstanding.

Simply put, the enterprise value is the entire value of the business, without giving consideration to its capital structure, and equity value is the total value of a business that is attributable to the shareholders.

Fair value less costs to sell is the arm's length sale price between knowledgeable willing parties less costs of disposal. The value in use of an asset is the expected future cash flows that the asset in its current condition will produce, discounted to present value using an appropriate discount rate.

Fair value accounting refers to the practice of measuring your business's liabilities and assets at their current market value. In other words, “fair value” is the amount that an asset could be sold for (or that a liability could be settled for) that's fair to both buyer and seller.

Why would you use equity method? ›

The equity method is used to account for investments in common stock or other eligible investments by recognizing the investor's share of the economic resources underlying those investments.

The equity method requires an investor to record its investment initially at cost (ASC 323-10-30-2 and ASC 805-50-30). An investor, however, may have a “basis difference” between the cost of its investment and the underlying equity in the net assets of an acquired investee.

Fair value is also used in a consolidation when a subsidiary company's financial statements are combined or consolidated with those of a parent company. The parent company buys an interest in a subsidiary, and the subsidiary's assets and liabilities are presented at fair market value for each account.

Typically, equity accounting–also called the equity method–is applied when an investor or holding entity owns 20–50% of the voting stock of the associate company. The equity method of accounting is used only when an investor or investing company can exert a significant influence over the investee or owned company.

The initial value method emphasizes the cost of the subsidiary and then uses the cash method instead of the accrual method. The company must use the cash method. On the other hand, the equity method is based on the accrual method. The company must use the accrual method with the equity method.

The cost method treats any dividends as income and can be taxed. On the hand, the equity method does not record dividends as income but rather as a return on investment and reduces the listed value of the investor's company shares. Accounting methods are typically used to record the value of the assets in a company.

C – Equity method goodwill is calculated as the excess of Investor's purchase price paid to acquire the investment over the fair value amounts assigned to the identified tangible and intangible assets and liabilities (fair value of Investor's share of Investee's net assets).