The effective yield method and the equity method are two different techniques for accounting for certain kinds of investments by limited partnerships in other companies. There are some cases in which investors and their accountants will choose between the two techniques.
A major difference between the equity method and the effective yield method is the prevalence with which they are used. The equity method is the standard accounting technique for a range of limited partnership investments, and it often is the required reporting method. It can be applied in more circumstances than the effective yield method, which can be used only in some circumstances when the investment is purchased with low-income housing tax credits.
Effective Yield Method Criteria
Three criteria must be met in order to use the effective yield method instead of the equity method. First, there must be a positive rate of return enjoyed by the investors from the tax credits. Second, the tax credits' availability to an investor receives a guarantee from an entity that is credit worthy. Third, the investors are limited partners in the project and their liability does not extend beyond capital investment in the project.
Mechanics and Benefit
The main advantage of using the effective yield method instead of the equity method is that it creates a more accurate gauge of the operating performance of the investment. The effective yield method involves recognizing tax credits as they are allocated and amortizing the initial investment. The equity method involves recognizing the credits as an increase in operating expenses or a decrease in pretax income.
The equity method and effective yield method are designed for accounting purposes for financial statements, but they are not utilized on tax returns. Instead, their main benefit is assessing investments, typically for companies that have significant stakes in outside investments.
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