Hi everyone,
My question relates to pratice problem 8 of reading 22, the effects of the equity method on EBIT.
Where is the proportionate share of net income due to an investment in an associate (20% share) reported in the financial statements? The answer to question 8 states that excluding the investment does not affect EBIT. Where else is the share of net income (equity method) reported?
Here is my answer but I am not sure if it is correct:
Since the investment does not imply control because of only a 20% share, the equity method is used. The equity method is a “one-line consolidation” method which means that the income statement is not affected, only the balance sheet reports the investment in the associate. Any share of net income will thus increase the carrying amount on the balance sheet.
Thanks for clarifying whether my explanation is correct.
Hi,
First of all EBIT is operating income and in Equity method, the operating income does not change. Second, in Equity method,the investor’s proportionate share of investee earnings ( net income) is reported within a single line item on its income statement. No dividends included
In the question, neither the interest expenses, nor the operating income will change. Net income will change
Hence no effect on Interest coverage ratios
I don’t like the CFAI answer here, though I see how they got it. If you look at p.376, they give an Income Statement that calls out “Share of Results of Associates” below EBIT. Some companies may present like this, but I do not beleive it is required under GAAP. At my current employer, we have a non-material amount of Equity Method Investments and it is above “Net Income before Taxes”. Ditto my previous employer where there was a very material Equity Method Investment. It was it’s own line on our audited financial statements, but it wasn’t below any pre-tax figure. And internally we absolutely considered it operating income since it was a former competitor. In fact, we consoldiated it for internal reporting purposes, but deconsolidated and showed it as an Equity Method Investment for audit purposes.
I chalk this up to being a bad question. If the question had the P&L and you could see they broke out, then fine. But I don’t like making an assumption that it is in a place there it very well may not be.
Okay, just for fun since my wife and kids left me to study for a couple hours. I just looked at GE’s financials, since they are big conglomerate that surely has some Equity Method Investments.
They report them in “Other Income”, which is a component of revenue, and obviously above EBIT.
p.128 is their Income Statement. “Other Income” references Note 7. Note 7 is on p. 193 and is says it includes income from Equity Investments. Boom.
Thsi is from the pdf of their 2014 10-K taken from GE’s Investor relations page. For some reason, I cannot paste the link.
Well, that was exactly my point. Thank you for looking up a reference in GE’s financials. I wasn’t sure whether or not the net income from the investment in the associate had to be included before or after EBIT. If it is included after EBIT: sure, no change to the interest coverage ratio. If it was included before EBIT though (as is the case with 40yoCFAcandidate’s previous two employers and also for GE) then interest coverage ratio would change.
The solution to question 8 of reading 22 states that there is no change which means that CFAI assumes that net income from equity method investments is included after EBIT.
If there is a question like this on the exam, I hope they tell us where the company put their Equity income. I just looked at two other random companies: 3M and Microsoft. Microsoft did put their Equity Income in an “Other Income, net” line below interest. 3M didn’t. Obvioulsy there is divresity in practice.