Why ROE is worse In acquisition compared to Equity Method?

CFA Level II FRA
#1

Hello, Since Equity (if new shares are not issued) and net income is not affected In acquisition and Equity Method then ROE = net Income/ Equity has to be same in both. Thanks

#2

Nope. Net income is the same in both methods, but the total equity in the acquisition method is higher than the total equity in the equity method by the extent of the minority interest.

Remember that in the acquisition method you merge both the IS and BS. On the equity part of balance sheet you will see the minority interest as a new account that increase total equity.

Since equity is higher in acquisition method and NI is the same, ROE is lower in this method than in the equity method.

#3

But if my minority interest is 0 , I acquired 100% then the equity will be same. In that scenario?

#4

If you own 100% of a business, then the equity method is discarded by default and the only accounting way would be the acquisition method. However, in that hypothetic case ROE under both methods would be equal.

#5

Both are affected.

Equity method:

  • parent 30 % share in “daughter”

  • 1st year after investements daughter realized 100 Net icome (suppose no dividends to simplfy this example)

  • 30 is shown in Parent’s P/L as revenue from invest in daughter, this this 30 is part of parent earnings and are in NI

Acquisition method

Parent has 100 % or 80 % (doesn’t matter) share in daugher, also there is a goodwill position in parent’s BS.

After 1 Y All daughter revenues and expenses are consolidated (merged) with parent’s R & E also BS positions.

ROE is lower by acquisition method because same nominator (assuming all else equal) NI is divided by greater amount of equity under acquistion method because of consolidation technique and goodwill position which pumped up the parent equity.

In first case ROE calculation (equity method) f.ex you have 30/100 compared to second (acquisition) f.ex. 30/150.

Same outcome for ROE you will get by each kind of pumping equity (eg. PPE revaluation under IFRS).

This is not always bad consequence because some other ratios (other than ROE) may get better such as solvency ratios, leverage ratios etc.

#6

In simplest terms:

Consolidated statements under Acquisition Method

  • More Net Income
  • More Equity

Consolidated statements under Equity Method

  • More Net Income
  • No more Sh Equity

ROE has to be higher under Equity Method.

#7

Thanks…