Page 19 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

Analytical Issues for Investments in READING 14: INTERCORPORATE INVESTMENTS
Associates

MODULE 14.5: INVESTMENT IN ASSOCIATES, PART 2

When an investee is profitable, and its dividend payout ratio < 100%,

• equity method earnings > other accounting methods used for minority passive investments.

You should consider if the equity method is appropriate for the investor.
• For example, an investor could use the equity method in order to report the proportionate share of the investee’s earnings, when it cannot actually
influence the investee.
• Also, the investee’s individual assets and liabilities are not reported on the investor’s balance sheet. The investor simply reports its proportionate share of
the investee’s equity in one line on the balance sheet.

By ignoring the investee’s debt, leverage is lower. In addition, the margin ratios are higher since the investee’s revenues are ignored.

The proportionate share of the investee’s earnings is recognized in the investor’s income statement, but the earnings may not be available to the investor in
the form of cash flow (dividends). That is, the investee’s earnings may be permanently reinvested.

Under the acquisition method, all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. Intercompany
transactions are excluded.

In the case where the parent owns less than 100% of the subsidiary, it is necessary to create a noncontrolling (minority) interest account for the
proportionate share of the subsidiary’s net assets that are not owned by the parent.