How is the ratio going to change if the accounting method changes from equity method to consolidation method? My answer would have been no change but Schweser says ratio will decrease?!
Your equity will increase if you do proportionate consolidation, leading the ROE to go down since NI will be the same.
I thought equity is not adjusted under the consolidation method? Is it because of minority interest? Does it mean: Equity (total) = Equity § + MI (Balance sheet)
When I say consolidation, i mean acquisition method
Equity is the same under Proportionate Consolidation. If you consolidate. (acquisition method) then your equity will increase because you are writing up the net identifiable assets to fair value and thus increasing the book value/equity of the firm. NI is the same under all methods. If equity increases then your ROE will decline as a result. ROE is lowest under the acquisition method.
Under Equity Method, you only recognize your investment (at cost) on the B/S. No impact on Equity. Under Proportionate Consolidation, you consolidate your % stake (usually 50%) of the subsidiary’s Assets and Liabilities. Since you are only consolidating your share proportionally, there is no impact on Equity. Under Consolidation, you consolidate the ENTIRE subsidiary, including the % you do not own. Because you have essentially over-allocated the subsidiary’s assets, you create an account called Minority Interest to account for % not owned in the Subsidiary. Minority Interest goes directly into S/E - and thus Equity INCREASES. Therefore, going from Equity Method to Consolidation means your Equity increases. And Net Income is the SAME under all THREE methods. Therefore; Equity Method ROE = Net Income (same) / Equity (same) Consolidation ROE = Net Income (same) / Equity (INCREASED by Minority Interest) Same numerator, higher denominator – therefore, ROE decreases under Consolidation. (There are a lot more details to this, but the basics are there!)
Thanks Chuckrox8, so to confirm ROE will be the same for equity method and proportionate consolidation but will be lower under acquisition Is this correct?
Yes correct. NI is the same across all methods. Equity Method - Lowest Equity (Highest ROE) Prop Consolidation - Lower Equity Acquisition (Partial Goodwill) - Higher Equity Acquisition (Full Goodwill) - Highest Equity (Lowest ROE)
ROA: Equity Method - HIGHEST Proportionate Consolidation - MIDDLE Consolidation - LOWEST ROE: E - HIGHEST PC - HIGHEST (same as Equity) C - LOWEST N/I E - SAME PC - SAME C - SAME Net Profit Margin E - HIGHEST PC - MIDDLE C - LOWEST