In the textbooks and answers to mock questions, CFAI states that shareholder equity is the same under the equity method and proportionate consolidation method. I think this makes zero sense. Let’s skip time zero (when the companies combine or whatnot) and go to the next year.
Hypothetical situation, Company A has 50% interest in Company B, a year later, Company B:
Reports NI of $10, and pays $5 in dividends
Equity method:
Report $5 of that net income on your income statement, flows to retained earnings, shareholder’s equity up $5
Proportionate consolidation:
Report $5 of that net income on your income statement, recognize the $2.5 dividend that’s paid out, retained earnings only changes by +2.5, shareholder’s equity up $2.5
Conclusion: How can shareholder’s equity be the same under equity and proportionate consolidation method if the equity method disregards dividends as it pertains to retained earnings, and proportionate consolidation does not? Please help, thanks ahead of time.
I may be wrong… it’s been a year since I’ve reviewed that… but, I believe under the equity method, dividends are treated as a return of capital in the investment in associates account, and increases cash, therefore, SE would be equal… You are correct in that under the equity method, dividends are not treated as a source of revenue/income which would then carry over to retained earnings, but cash (an asset) increases. Cash obviously does not increase your liabilities, hence, it has to increase your equity.
Under equity method, the investment in associate is recorded as an investment account under asset. Proportionate amout of investee’s net income will increase this investment account. If investee pay dividend during the period, the proportionate amount of dividend will also be deducted from this investment account.
Hence, in your example, investment account will decrease by 2.5, which translate to decrease of 2.5 for SE.
So, maybe this will help others, but thanks to those that have answered. The answers to my post have been similiar to other posts in the past, which is why I posted this question (been a lurker the past 1.5 years mostly), because most people who answer talk to the equity method about the asset side, which is pretty simple (shareholders equity go up $5, the investment only goes up $2.5 because 50% of $10 NI - $5 dividend, but cash ALSO goes up 2.5 for the div), but that isn’t what’s confusing.
I talked with a coworker and realized, the reason why shareholder equity is the same under the equity method and the proportionate consolidation method is because equity method does NOT recognize dividend, BUT, NEITHER does the proportionate consolidation method because it’s treated as a intercompany transaction (whole nother topic, don’t worry, I also skipped posts with that as an answer as my question as well, because I didn’t want to read more than I may have needed to), thus proportionate consolidation in my example, also sees their RE increase by 5.
Hope this helps, I feel no where as confident as I did a few months ago for level 1 as I do now for level 2, taking all of next week off from work to study, hope it is enough for me to get by, CFA has been rough on life…