Effect of Different Accounting Methods for Intercorporate Investments on the Financial Statements

Equity Method

The equity method of accounting provides a more objective basis for reporting investment income. The investor is required to recognize income as earned rather than when dividends are received. Thus, an equity investment is reported as a single line item on both the balance sheet and income statement. Nonrecognition of the debt results of the investee leads to lower leverage ratios. Furthermore, the nonrecognition of the investee’s revenues results in higher profit margins.

Acquisition Method

The acquisition method is used to account for business combinations. Under this method, provided that the parent has control over the subsidiary, it would include 100% of the subsidiary’s assets and liabilities at fair value on the consolidated balance sheet.

Therefore, the acquisition method leads to higher assets, liabilities, revenues, and expenses than the equity method. Net income is the same under both methods.

Additionally, under the acquisition method, the full goodwill method leads to higher total assets and equity relative to the partial goodwill method. Thus, the return on assets and return on equity will be lower if the full goodwill method is applied. Retained earnings and net income are the same under both methods, but shareholders’ equity is different. The difference is because of different non-controlling interests.

Proportionate Consolidation

Joint ventures occasionally use proportionate consolidation. It requires a combination of the venture’s share of the assets, liabilities, income, and expenses of the joint venture or to be presented on a line-by-line basis with similar items under sole control as opposed to the equity method results in a single line item on both the balance sheet and income statement. However, both methods report the same equity.

Example: Acquisition Method and Proportionate Consolidation

ABC Ltd. owns a 20% interest in a joint venture, XYZ, and accounts for it using the equity method. The assets and liabilities of XYZ have a book value equal to their fair value. The companies have each reported the following 2020 financial results:

$$\small{\begin{array}{l|c|c} \textbf{Balance Sheet}& \textbf{ABC} & \textbf{XYZ} \\ \hline
\text{Cash}& 2,000 & 500 \\ \hline\text{Accounts receivable} & 4,000 & 1,000 \\ \hline\text{Inventory}& 3,500 & 1,200 \\ \hline\text{Fixed assets} & 6,000 & 3,000 \\ \hline\text{Investment in XYZ} & 450 & \\ \hline\text{Total assets} & \text{15,950} & \text{5,700} \\ \hline{} & & \\ \hline \textbf{Accounts payable}  & 4,000 & 1,500 \\ \hline\text{Long term debt} & 5,000 & 3,000 \\ \hline\text{Equity} & 6,950 & 1,200 \\ \hline & \textbf{15,950} & \textbf{5,700} \\ \hline & & \\ \hline\textbf{Income statement} & & \\ \hline\text{Revenues} & 20,500 & 3,500 \\ \hline\text{Equity in JVC earnings} & 200 & \\ \hline\text{Cost of goods sold} & 6,000 & 2,500 \\ \hline\text{Other expenses} & 13,000 & 600 \\ \hline\text{Income before tax} & 1,700 & 400 \\ \hline\text{Tax} & 1,000 & 200 \\ \hline\textbf{Net income} & \textbf{700} & \textbf{200}\\  \end{array}}$$

    a. Determine ABC’s stockholders’ equity and total assets at the end of 2020, assuming consolidation using the acquisition method.

Solution

ABC’s Stockholders’ Equity

ABC would include minority interest (20% of $1,200) along with its equity of $6,950 in the consolidated financial statements.

$$\text{ABC’s stockholders’ equity}=(20\%\times 1,200)+$6,950=$7,190$$

Total Assets

ABC would include all the assets of XYZ and remove its equity investment in the consolidated balance sheet.

$$\text{Total assets}=($15,950− $240) + $5,700 = $21,7410$$

    b. Determine ABC’s cost of goods sold and the net income for the year ended 2020, assuming proportionate consolidation.

Solution

Cost of Goods and Services

$$\text{COGS} = $6,000\ \text{ABC}+ 20\%\ \text{of}\ $2,500\ \text{XYZ} = $6,500$$ 

Net income

Net income of $700 is unaffected by proportionate consolidation.

Effect of Different Accounting Methods on Ratios

Return on Equity (ROE)

The equity method leads to a higher ROE since equity is lower and net income is the same. The same applies to the proportionate consolidation method. However, under the acquisition method, ROE is lower.

Return on Assets (ROA)

The equity method results in a higher ROA as net income is the same, but assets are lower. It is the same for the proportionate consolidation method. ROA will be lower under the acquisition method.

Net Profit Margin

The equity method leads to a higher return on profits as sales are lower and net income is the same. It will be in-between under the proportionate consolidation method and lower under the acquisition method.

Summary: Financial Results under Different Accounting Methods

$$\small{\begin{array}{l|l|l|l} {}& \textbf{Equity Method} & \textbf{Proportionate Consolidation Method} & \textbf{Acquisition Method}\\ \hline\text{Net income} & \text{Same} & \text{Same} & \text{Same} \\ \hline\text{Total Assets and liabilities} & \text{Lower} & \text{In-Between} & \text{Higher} \\ \hline\text{Equity} & \text{Same} & \text{Same} & {\text{Higher by the amount of}\\ \text{minority interest}}\\ \hline\text{Revenues and expenses} & \text{Lower} & \text{In-between} & \text{Higher}\\ \hline\text{Leverage} & {\text{Lower} (\text{liabilities are lower and}\\ \text{equity is the same})} & \text{In-between} & \text{Higher} \\ \hline\text{Net Profit Margin} & {\text{Higher} (\text{sales are lower}\\ \text{and N.I. is the same})} & \text{In-between} & \text{Lower} \\ \hline\text{ROE} & {\text{Higher} (\text{equity is lower}\\ \text{and N.I. is the same})} & \text{Same} & \text{Lower} \\ \hline\text{ROA} & {\text{Higher} (\text{N.I. is the same and}\\ \text{Assets are lower})} & \text{In-between} & \text{Lower} \\ \hline\text{Interest coverage ratio} & \text{Higher} & \text{In-between} & {\text{Lower } (\text{because of higher}\\ \text{interest expense})} \\ \hline\text{Net Profit Margin} & {\text{Higher} (\text{sales are lower}\\ \text{and N.I. is the same})} & \text{In-between} & \text{Lower} \\ \hline\text{Operating income} & \text{Lower} & \text{In-between} & {\text{Higher } (\text{in most cases,}\\ \text{minority interest is reported}\\ \text{below the operating line on}\\ \text{the consolidated income}\\ \text{statement})}\\  \end{array}}$$

Question

When accounting for intercorporate investments using the equity method, relative to the acquisition method, return on assets is most likely to be:

1. Higher.
2. The same.
3. Lower.

Solution

The correct answer is A.

The equity method and the acquisition method report the same net income. However, assets and liabilities are highest under the acquisition method and lowest under the equity method. It implies that ROA will be higher under the equity method (smaller denominator) relative to the acquisition method). 

B is incorrect. ROA will be in-between when using the proportionate consolidation method.

C is incorrect. ROA will be lower under the acquisition method.

Reading 11: Intercorporate Investment

LOS 11 (c) Analyze how different methods used to account for intercorporate investments affect financial statements and ratios.