Impact of Different Accounting Methods on Financial Ratios

CFA Level II FRA
#1

Hi All,

I am having a hard time understanding the following differences between the equity and acquisition method:

Leverage Ratio : Better (lower) under equity method as liabilities are lower and equity is the same

ROE : Better (higher) under equity method as equity is lower and net income is the same

Would anyone be able to explain why equity is the same when utilizing leverage ratios but lower when looking at ROE? Let’s say Company P invests $8,000 in cash to acquire 80% of Company S. At the end of the year, company S earns $4,000 net income and pays $1,000 dividends. Under the two methods:

Equity Method:

Income Statement : Earnings from Company S: $3,200

Balance Sheet : Investment in Company S: $10,400 ($8,000+$3,200-$800)

Balance Sheet : Cash: -$7,200 (-$8,000+$800)

Equity** :** $3,200

Acquisition Method (Assuming No Up/Downstream Sales):

Income Statement: Net Income $4,000 ($800 of which was minority interest)

Balance Sheet: Assets increase by $4,000

Equity: Increases by $4,000 (RE & Minority Interest)

To me it seems as though equity is always higher under the acquisition method, am I missing something? Thanks for your help!

#2

It depends on whether you include minority interest in equity (under the acquisition method): if you do, then equity is higher; if you don’t, then equity is the same.

#3

Thanks S2000magician, I really appreciate your help!

Just so I am sure I understand correctly, the only time minority interest would not be included in equity would be if 100% was acquired right? I thought I remember seeing that minority interest could have been classified as a liability in the past, do you know if this is still an option?

#4

Minority/Non-Controlling interest is part of equity.

So as S2000 explained above, if you acquire less than 100% and use Acquisition method, equity is higher due to non-controlling interest being recognised under S.E. vs. in Equity Method where you dont have any impact ,since Equity method of accounting is essentially a one-line consolidation (under non-current assets).

I think you need to be careful with the calculation above, If i recall correctly, the CFA EOC problems ask for an ‘immediate impact’/‘the very next instant’ on S.E. or other line items (under different methods) and NOT after one year…that said they can certainly ask what happens after one year and for this one will have to do the calculations with the given information in the problem.