In 2012, Chevron reported net income of $26.3 billion, $6.9 billion of which was income recognized on investments in affiliate companies accounted for under the equity method. In that same year, Chevron received much less than that amount in dividends from these affiliates. Some accountants have argued that the net income amount reported by Chevron from the equity method is distorted because the company received much less cash on its investment.
a. Comment on this criticism of the equity method. In your answer, explain the accounting procedures that characterize the equity method and why income is recognized that is not always backed up by cash receipts. Also explain why investors and creditors must be careful when analyzing financial statements that reflect the use of the equity method.
b. Chevron uses the indirect method of presenting the statement of cash flows. Indicate the direction of the adjustment to net income associated with earnings and dividends under the equity method that appears in the operating section of the statement.