An investment manager is constructing a financial statement model for 'Global Logistics Inc.' The company recently acquired a 25% stake in 'Freight Forwarders Ltd.' for $100 million, obtaining significant influence but not control. Freight Forwarders Ltd. reported net income of $20 million and paid dividends of $5 million during the year. Global Logistics Inc. accounts for this investment using the equity method. How will this investment impact Global Logistics Inc.'s cash flow statement for the year?
- AAn inflow of $5 million in operating activities.
- BAn outflow of $100 million in investing activities and an inflow of $1.25 million in operating activities.
- CAn outflow of $100 million in investing activities and an inflow of $1.25 million in investing activities.
- DAn inflow of $5 million in investing activities.
Show answer & explanationAnswer & explanation
Correct answer: B. An outflow of $100 million in investing activities and an inflow of $1.25 million in operating activities.
The initial acquisition of the 25% stake ($100 million) is a cash outflow for investing activities. Under the equity method, the investor's share of the associate's net income is not a cash flow item but affects the investment account and the income statement. Dividends received from the associate are recognized as a cash inflow. Under U.S. GAAP, dividends received from an equity method investment can be classified as either operating or investing activities. However, CFA Institute curriculum often presents them as operating cash flows unless specified otherwise for specific contexts. Share of dividends received = 25% * $5 million = $1.25 million. This is an inflow in operating activities.
Why the other options are wrong
- A. Incorrect. This only accounts for the dividends received but miscalculates the amount and ignores the initial investment outflow.
- C. Incorrect. While the initial investment is investing, classifying dividends received as investing activities is also acceptable, but the question implies the most common presentation in a general context. However, given the options, if classifying dividends as investing, the amount is correct. But the CFA curriculum often defaults to operating for dividends from equity method investments unless specifically indicated for IFRS where it can be consistent with interest/taxes (operating) or investing.
- D. Incorrect. This only accounts for dividends and miscalculates the amount, ignoring the initial investment.
Equity Method - Cash Flow Impact
Under the equity method, the initial investment is an investing cash outflow. The investor's share of the associate's net income is a non-cash item. Dividends received from the associate are cash inflows, typically classified as operating activities (U.S. GAAP) or operating/investing (IFRS).
- Acquisition of investment: Investing cash outflow.
- Share of investee's net income: Non-cash, affects income statement and investment account.
- Dividends received: Cash inflow.
- U.S. GAAP: Dividends from equity method usually operating cash flow.
- IFRS: Dividends from equity method can be operating or investing.
Memory trick: Buy it (investing), earn it (no cash), get dividends (operating cash).