Equity Vs Proportionate Consolidation

CFA Level II
#1

Why would the shareholder’s equity be same under both the methods?

If assets of the joint venture are added to the BS, then how could equity be the same?

#2

Think of this in the different stages of the investment

  • When initial investment is made
  • How these values change over time
  • Then after 1-year how the values change

Initial Investment

Equity Method = “one line consolidation”

So you are Firm X and you spend $100 buying a 20% interest in Firm A

  • Cash goes down by $100
  • Add a line item in Assets for the investment in Firm A = $100

1-year Later

Firm A reports $150 in total earnings for the year & paid $40 in dividends

  • Firm X adds its earnings pickup to the I/S ( $150 * 20% = $30 )
  • Firm X dividends from Firm A = $8
  • Firm X B/S line item change is then = $100 + $30 - $8 = $122 at year end
  • Firm X total change in retained earnings will be adding their net income (less dividends) to the balance sheet

When you do proportionate consolidation you are allocating your % ownerships of a firm’s assets & liabilities to the balance sheet.

1-year Later

Firm Y invests in Firm B*

* Same $100 amount and 20% ownership

  • Firm Y reports revenue, expenses, etc = their % ownership of Firm B on the I/S
  • Firm Y reports A/R, A/P, LT Debt, Inventory, etc = their % ownership of Firm B on the B/S
  • Firm Y retained earnings change = net income - dividends

Keep this in mind as well.

Net Income = Equity Method = Proportionate Consolidation

Shareholder Equity = Equity Method = Proportionate Consolidation

ROE = same under both

However most other ratios will be different!