Equity Method: 25% ownership, EPS affecting income statement?

CFA Level II FRA
#1

Just ran into this question and not sure why we are looking at EPS in the answer. I honestly would have thought it was -250,000 since that’s what was spent for the shares. :

  • Mashburn Company acquired 25% of the 100,000 outstanding shares of Humm Co. on January 1 for $250,000 in cash.
  • Humm Co. earned $1 per share and had a dividend payout ratio of 40%.
  • As of December 31, Humm Co. shares were trading in the open market at $12 per share.
  • Calculate the income statement treatment of the Humm Co. investment as of December 31.

A) $75,000

B) $25,000

C) $10,000

Answer: Under the equity method, the investor recognizes its pro-rata share of the affiliate’s income on the income statement. Since Mashburn owns 25,000 shares of Humm and Humm earned $1, the income statement impact of the investment is $25,000.

#2

What you spend for an investment does not appear on the income statement.

#3

Magician - thank you all the help you provided me in Level 1.

Magician: how come it is not C? Wouldn’t income statement reflect the income after dividends are paid?

-Joe

#4

Under the equity method:

  • On the income statement you record your share of the subsidiary’s net income.
  • On the balance sheet you:
    • Increase the investment in the subsidiary by your share of the subsidiary’s net income,
    • Increase cash by the dividends received, and
    • Decrease the investment in the subsidiary by the dividends received.

So, here:

  • Mashburn’s original investment in Humm is $250,000.
  • Mashburn shows $25,000 in income from Humm on its income statement.
  • Mashburn increases its investment in Humm by $25,000
  • Mashburn increases its cash by $10,000 for the dividend it receives.
  • Mashburn decreases its investment in Humm by $10,000 for the dividend it receives.
  • Mashburn’s ending investment in Humm is $265,000 (= $250,000 + $25,000 − $10,000).
#5

This is a good explanation thanks!

#6

My pleasure.