Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the key difference in how sales, cost of sales, and expenses are reported under the equity method compared to proportionate consolidation?

1. They are not reported at all in the equity method

2. All components are shown separately

3. They are reflected in multiple lines in financial statements

4. They are reflected in a single line in the financial statements

The correct answer is: They are reflected in a single line in the financial statements

Under the equity method, the key aspect is that the investor reports its share of the investee's profits and losses as a single line item in their financial statements. This reflects the concept that the investment is not directly tied to the operational results of the investee; rather, it represents an ownership stake. Thus, the investor recognizes their share of the investee's income, which consolidates the effects of sales, costs, and expenses into one summarized figure. This contrasts with proportionate consolidation, where the investor directly includes their proportional share of the revenue, expenses, and profits from the investee in the investor's financial statements. In proportionate consolidation, components like sales, costs of sales, and other expenses are accounted for separately, providing a more detailed picture of the underlying financial activities of the investee as it relates to the investor. Therefore, the essence of the equity method is encapsulated in the idea of reporting the investment's performance as a single line, reflecting the consolidated ownership perspective.