Final answer:
Compensation plans based on annual income can lead to unintended wealth transfers from owners to managers when using the cost method of accounting, as it allows for earnings manipulation. The equity and fair value methods, however, align reported income with a company's economic performance and market value, reducing this risk.
Step-by-step explanation:
The question explores how compensation plans, which reward managers based on reported annual income, might encourage unplanned wealth transfers from owners to managers when the cost method is used to account for investments in which a firm has significant influence. Under the cost method, investments are recorded at cost, and any subsequent changes in value are not reflected until the investment is sold. This presents an opportunity for managers to manipulate reported earnings, which can lead to bonuses or rewards, without truly reflecting the underlying economic reality.
Contrastingly, the equity method and fair value method involve recognizing changes in the value of the investment in the company's financial statements. Under the equity method, a company recognizes its share of the profits and losses of the investment in its own income, which aligns the company's reported income more closely with its true economic performance. The fair value method, on the other hand, involves regular revaluation of the investment to its current fair market value, which is also recorded in income statements, providing an up-to-date reflection of the investment's value.
Given this, the equity and fair value methods create incentives for managers to focus on the actual economic performance and fair value of the investments, thereby potentially reducing the risk of unintended wealth transfers from owners to managers that can be associated with the cost method.