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 cost method of accounting for significant investments have resulted in unintended wealth transfers from owners to managers? Do the equity or fair-value methods provide similar incentives? Explain.