Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the treatment of investment under the Equity Method?

1. Investment recognized at market value only

2. Investment recorded as cost on the balance sheet

3. Investment valued at liquidation value

4. Investment recorded at book value

The correct answer is: Investment recorded as cost on the balance sheet

Under the Equity Method of accounting for investments, an investor recognizes its investment in a company at cost on the balance sheet and subsequently adjusts this value for its share of the investee's profits or losses. When the investee earns profits, the investor's share of those profits increases the carrying amount of the investment, while losses would decrease the carrying amount. Dividends received from the investee also reduce the investment's carrying amount. This method reflects the investor's significant influence over the investee, typically present when the investor holds 20% to 50% of the voting shares. The other alternatives do not accurately represent the treatment under the Equity Method. Market value, liquidation value, or book value without adjustments are not consistent with the accounting principles governing the Equity Method, which emphasizes the investor's proportionate share of the investee’s net income or loss.