How do upstream and downstream transactions affect equity method accounting?

This is a tricky area that the CFA Level II exam loves to test. Let me break it down:

Definitions:

• Downstream transaction: The investor sells goods/services TO the investee (associate)
• Upstream transaction: The investee (associate) sells goods/services TO the investor

In both cases, any unrealized profit from the transaction must be eliminated proportionally.

Worked Example — Downstream:

Riverton Manufacturing (investor, 40% stake) sells inventory costing $200,000 to its associate, Crestview Components, for $300,000. At year-end, Crestview still holds 60% of this inventory unsold.

1. Total gross profit on sale = $300,000 - $200,000 = $100,000
2. Unrealized portion = $100,000 x 60% = $60,000 (still in Crestview's inventory)
3. Investor's share to eliminate = $60,000 x 40% = $24,000

Riverton reduces its equity income by $24,000 and reduces the investment account by the same amount.

Worked Example — Upstream:

Crestview Components sells inventory costing $150,000 to Riverton for $225,000. At year-end, Riverton has sold 70% of these goods to third parties.

1. Total gross profit = $225,000 - $150,000 = $75,000
2. Unrealized portion = $75,000 x 30% = $22,500
3. Investor's share to eliminate = $22,500 x 40% = $9,000

Key distinction for the exam:

• Under IFRS, the treatment is the same for both upstream and downstream — eliminate the investor's proportionate share.
• Under US GAAP, downstream transactions require the investor to eliminate 100% of the unrealized profit (not just its proportionate share), since the investor controlled the sale.

This GAAP vs. IFRS difference is a high-probability exam question. Practice both scenarios in our CFA Level II Financial Reporting module.