CFAi Reading 19 Q 23

CFA Level II
#1

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Hi there,

BetterCare must use Equity Method as it reports under US GAAP

Supreme HealthCare (according to the wording of the problem) uses proportionate consolidation

The answer is C, the shareholder’s equity is the same under both method.

I understand that the Equity Method does not affect shareholder’s Equity but I don’t understand why the proportionate method has no effect on it. That I am not too sure.

I thought that the proportionate consolidation method was similar to an acquisition method unless it consolidates the prorata that the parent company owns and therefore does not need a minority (non controlling) interest account. But if that the case don’t we add the prorata share of the investee’s equity onto the consolidated shareholders’ equity ?

Thanks in advance for your help :slight_smile:

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#2

PhilMtx, under the Equity method shareholders’ equity is impacted. The income statement includes a share of the join venture’s/associate’s net income. Whatever passes through the income statement ultimately ends up impacting equity (retained earnings).

#3

I agree with the logic, but in the solutions of end of chapter questions, it repeatedly mentions that Shareholder’s equity is unchanged. They must make some kind of assumption that explains why they consider shareholder’s equity not to be impacted.

#4

If we take the answer to question 23 alone, it only implies that the choice of method does not affect equity, which I would understand to mean that both methods affect in the same way.

#5

Hi PhilMtx

Both Equity Method and Proportionate Consolidation Method affect Shareholders Equity but in the same way. Also, you should look at it from the view of events both on the Acquisition date and Post Acquisition date.

If you consider what happens on the acquisition date:

Company A acquires 25% stake in Company B, by cash, uses Equity Method.

On Acquisition date:

Cash reduces, Investment Account increases - Both of them are asset accounts so Shareholders Equity is not affected on acquisition date.

After Acquisition date:

If company B reports x amount of Net Income and declares y amount of dividend, Company A’s financial statement will reflect

  1. Dividend paid by company B - A reduction in Investment Account and an increase in Cash - Both of them are asset accounts, which makes the balance sheet balanced. So shareholders equity for company A is not affected by the dividend paid by company B

  2. Net income paid by Company B- An increase in Investment Account and an increase in Retained Earnings (which is a part of shareholder’s equity). Si shareholders equity for company A is affected by the Net Income made by company B.

If we assume this is a Joint Venture and Proportionate Consolidation Method is used by Company A

On Acquisition date:

Company A records proportionate amount of Assets and Liabilities held in Company B. Again, if this was paid for by cash, Company A’s balance sheet will refelect a decrease in Cash and an increase in Net Assets (i.e proportionate Amount of Assets - Liabilities) - Again the balance sheet equation is stable and shareholders equity is not Affected.

After Acquisition Date:

Company A reports proportionate amount of Revenue, Gains, Losses and Expenses made by Company B. This is reflected in Company A’s Net Income which gets carried to retained earnings and shareholders equity, so shareholders equity is affected.

In Both cases, i.e Equity Method and Proportional Consolidation method, the Net Income is the same, the Net asset is the same Shareholder’s Equity is the same but Revenue, Expenses and Liabilities differ for both and this will also mean a difference in stuffs like Asset turnover ratios and leverage ratios.

Also, in Both cases, if Company A had paid for aquisition of it’s stake in Company B by issuing new shares:

On the Acquisition Date if Equity Method is used:

Company A would report an Increase in Investment Account and an Increase in Additional Paid in Capital (which is a component of Shareholder’s equity and would mean an increase in Shareholder’s equity)

If Proportionate Consolidation Method is used:

Company A would report an increase in assets and liabilities (i.e an Increase in Net Assets) but also an Increase in Additional Paid in Capital, which will also mean the Shareholder’s Equity is affected on acquisition date.

1 Like
#6

Thanks bloodline, that helps a lot :slight_smile: