Chartered Financial Analyst (CFA) Practice Exam Level 2

In the equity method of accounting, how is the investment initially recorded on the balance sheet?

1. At fair value

2. At cost

3. At market price

4. At net asset value

The correct answer is: At cost

In the equity method of accounting, the investment is initially recorded on the balance sheet at cost. This reflects the amount paid for the investment, including any transaction costs that are directly attributable to the acquisition. This method is employed when an investor has significant influence over the investee, typically indicated by ownership of 20% to 50% of the voting shares. After the initial recognition, the carrying amount of the investment is subsequently adjusted for the investor's share of the investee’s profits or losses, as well as any dividends received, which is why it is crucial to start at cost. This practice ensures that the investment reflects both the initial outlay and impacts over time due to the investor’s proportional share of the investee’s performance. The other methods cited, such as fair value, market price, or net asset value, do not apply to the initial recognition of investments under the equity method. Fair value might be relevant in other contexts, such as certain investment classifications or when assessing other types of equity investments, but it does not pertain to the way investments are recorded under the equity method from the outset.