COURSE NAME: ADVANCED ACCOUNTING
Accounting For Investments
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Question 1: Compare and contrast the methods that can be used in accounting for investments. How does a company choose a method? What are the advantages and disadvantages of each?
Answer: The investments are the most important asset for any company and there are various ways of accounting for investments. The accounting for investments general happens when a particular company makes a payment or pays funds for an investing instrument. The two most important methods which are used for accounting of investments are the cost and the equity method. The most common method that is used in order to account for investments is the cost method. In this method, the actual cost of the investment is taken as the base. Under this method, the value of the investment does not get changed between the time when the investment is bought and sold. Only the dividend income is considered which are recorded as income whenever the company issues any dividends. The cost method is generally used by companies that tend to make a long-term investment. Under the cost method of accounting, the stock is recorded in the balance sheet at its historical cost, which is the cost of acquiring the stock. This is reported as the non- current asset on the balance sheet.
The equity method of accounting for investments on the other hand is generally used by companies when the investor owns at least and more than 20% of the stocks of the company, unlike the cost method which can be used below 20% also. This means that this method is used only when the investor has a significant influence o control over the other company. Initially these investments are recorded at cost just like the cost method. But, in later periods the investor tends to recognize its losses and gains on the investment. This is done after the losses and gains of intra entity has been deducted. The dividends, if any issued by the investee are deducted from the balance in the investment account.
A company should be very careful while deciding the method for accounting of investments. This depends on a lot of factors like how long the company intends to hold the stock and what it wants to do with stock acquired like to be held or for sale. If the company wants to hold the stock for a longer period of time then definitely the cost method should be used, otherwise the equity method should be selected.
There are several advantages as well as disadvantages of cost and the equity method. The advantage of the equity method is that it tends to be more accurate and provides more accurate income balances. It also helps in hiding the figures that are unfavourable. Its disadvantage is that the method is very difficult to use and understand and it shows dividends as deductions and not incomes. The advantage of the cost method is that it is easy to use and involves less paperwork and also the dividends that are issued are taken into account as income on the income statement and not deductions. Its only disadvantage is that this method of investment is not useful for daily business and investment decisions.
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