Mechanics of Investment Income 3 Financial Statements

Question relates to the below. Just wondering could someone provide an example as to how it works in practice. So say net income after tax of the affiliate is 10. Net Income up 10. Retained Earnings increased by 10 (by virture of assuming no dividends apportioned). Investment asset up by 10. Is there an effect on cashflows as I imagine that this addition to retained earnings is non-cash which leads to a reduction in cash and throws the balance out of whack. What am I missing?

"Wall Street Prep" First to be clear, we are talking about the equity method in this case, which applies to how investors must account for investments where they own roughly 20-50% of the entire business.

On day one, the initial investment is debited (an investment asset is created) and the form of consideration (cash or debt or equity) is credited.

During the year, the after-tax net income generated by the affiliate is recognized, pro rata, as investment income on the income statement. Back on the balance sheet, the impact is reflected as a credit to RE and as a debit to the investment asset (if the affiliate reported losses, it would be the opposite.

On the cash flow statement, this net income is added back since it is non cash, while any dividends received by the investor are reflected as an increase in cash.

Back on the balance sheet, dividends reduce the carrying value of the investment asset (similar conceptually to why RE is reduced by common dividends), with a corresponding debit to cash.

Hope that helps. In case you're curious, there is another, although usually immaterial wrinkle in the accounting of affiliate investments: Although the income from affiliates reported on the income statement is reported net of tax (i.e., the affiliate has presumably paid taxes at the corporate level on the pre-tax income generated), the investor will also pay a second cash tax at some point: either through the recovery of the investment via dividends, or ultimately via a gain on the sale of the investment at the following rates:
Dividends: The tax on dividends is currently low – since 80% of dividends received are tax free, the corporate tax only applies on the remaining 20%. As such, the total tax on dividends at a corporate tax rate of 35% is 20% x 35% = 7%, Gain on sale: fully taxed at the corporate level

While these cash taxes will have to get paid at some point, GAAP requires that income from affiliates be taxed when it is earned (remember the accrual concept of accounting). As such, this creates a timing difference between book and IRS taxes. As a result a deferred tax liability is created when the company records income in affiliates, and the DTL is reversed whenever dividends or sale proceeds are received.

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