CFA Level II ExamFinancial Statement AnalysisEasy
A financial analyst is evaluating the financial statements of a U.S. company (reporting currency USD) that has a 35% equity investment in a foreign associate, 'Global Ventures.' Global Ventures operates in a country whose functional currency is the euro (€). The analyst notes that during the year, Global Ventures reported net income of €5,000,000 and paid dividends of €1,000,000. The average exchange rate for the year was $1.20/€, and the exchange rate at the date dividends were received was $1.22/€. The U.S. company's share of Global Ventures' net income, as reported on its income statement under the equity method, would be closest to:
- A$2,135,000
- B$2,100,000
- C$1,750,000
- D$2,170,000
Show answer & explanationAnswer & explanation
Correct answer: B. $2,100,000
Under the equity method, the investor recognizes its share of the associate's net income. This share is translated at the average exchange rate for the period. Dividends received reduce the investment account but do not directly impact the income statement recognition of the share of net income.
Why the other options are wrong
- A. Incorrect. This calculation inappropriately mixes dividend date and average rates or includes dividends in the income calculation.
- C. Incorrect. This calculation translates net income using the dividend date exchange rate, which is incorrect for income statement recognition under the equity method.
- D. Incorrect. This calculation incorrectly uses the dividend date exchange rate for the entire net income or applies an incorrect percentage.
Equity Method Income Recognition (Foreign Associate)
Under the equity method, an investor recognizes its proportionate share of a foreign associate's net income, translated at the average exchange rate for the reporting period.
- Applicable for significant influence (20-50% ownership typically).
- Share of net income increases the investment account and is reported on the investor's income statement.
- Dividends received reduce the investment account but do not affect income statement recognition of the share of net income.
- Average exchange rate is used for income statement items.
Memory trick: Equity shares good times (income) at the average party rate, but dividends just reduce the tab.