In 1994 Texaco reported net income of $910 million, $494 million of which was income rec¬ ognized on investments in affiliate companies accounted for under the equity method. In that same year Texaco received much less than that amount in dividends from these affiliates. Some accountants have argued that the net income amount reported by Texaco from the equity method is distorted because the company received much less cash on its investment. REQUIRED:

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 care¬ ful when analyzing financial statements that reflect the use of the equity method.

b. Texaco 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.