Do THE COST METHOD INVITE EARNINGS MANIPULATION?

Prior to GAAP for equity method investments, firms used the cost method to account for their unconsolidated investments in common stock regardless of the presence of signifi- cant influence. Under the cost method, when the investee declares a dividend, the inves- tor records dividend income. The investment account typically remains at its original costhence 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 invest- ments have resulted in unintended wealth transfers from owners to managers? Do the equity or fair-value methods provide similar incentives?