Chartered Financial Analyst (CFA) Practice Exam Level 2

How are earnings recognized in the equity method for an investment between 20% to 50% ownership?

1. Through full consolidation of all accounts

2. By recognizing only the dividends paid

3. As a proportionate share of the earnings

4. As an interest income

The correct answer is: As a proportionate share of the earnings

In the equity method of accounting, an investor recognizes earnings based on their proportionate share of the investee's earnings when they have significant influence, typically indicated by an ownership stake of 20% to 50%. This method reflects the economic reality that the investor is entitled to a share of the profits generated by the investee, consistent with their equity stake. When using the equity method, the investor does not consolidate the financial statements of the investee; instead, they recognize their share of the investee's net income directly on their income statement. This recognition occurs regardless of whether the investee has actually distributed dividends. Therefore, the investor’s investment account is adjusted upwards by the proportionate share of the investee’s earnings and downward when there are losses, thus reflecting the underlying performance of the investee over time. In contrast, full consolidation would apply when the ownership exceeds 50%, which is not relevant in this context. Recognizing only the dividends paid would not accurately reflect the earnings of the investee and would ignore the investee's overall financial performance. Lastly, categorizing the recognition as interest income is inappropriate, as the earnings recognized are derived from the investee’s operational performance rather than interest earned from lending activities. This approach ensures