It seems to me as if proportional consolidation is truest to the economic substance of inter-corporate investments. I do not understand why it is not used all the time. It is only rarely used, in rare cases for joint ventures.
Proportional consolidation seems to me to be the only of the three methods (equity and acquisition methods and proportional consolidation) that does not skew financial ratios in weird ways. Yet it is almost never used.
Disadvantages of the equity method:
- Reduces assets and liabilities by netting them against one another. How can this ever be truer to the economic substance than proportional consolidation?
- Artificially boosts the net profit margin (NI/Sales) by understating sales – the sales of the investee are not included in the ratio. In effect, the net profit margin becomes (NI of BOTH the parent and investee)/(Sales of the parent only). Weird.
- Artificially boosts the return on assets by understating assets. Instead of computing (NI of parent + investee)/(Total assets of parent + TOTAL assets of investee), which would be true to economic substance, it computes (NI of parent + investee)/(Total assets of parent + NET assets of investee). If the investee is highly leveraged, its net assets will be much smaller than its total assets, overstating the ROA ratio of the parent.
- Can make the parent appear less leveraged than it actually is, because it only reports the net assets of its investments.
Disadvantages of the acquisition method:
- Overstates the net profit margin (NI/Sales) by including sales that belong to minority interests.
- Overstates the ROE (NI/SH equity) by including in SH equity minority interests.
- Overstates ROA (NI/Assets) by including in assets those that belong to minority interests.
Disadvantages of the proportional consolidation method: ???
Advantages of the equity method: Quick and dirty for those that prepare the statements.
Advantages of the acquisition method: ???
Advantages of proportional consolidation: True to economic substance.
Perhaps proportional consolidation has disadvantages of which I am not aware of. But if proportional consolidation has no significant disadvantage, why don’t IFRS and US GAAP require its use all the time (perhaps with limited exceptions, e.g. for mutual funds or very small investments)?