Why is Equity the same no matter whether you’re using the Equity, Porportionate Consolidation, or Acquisition methods? I understand why NI is the same but am not wrapping my head around why Equity would be as well. Please point out my flawed accounting mechanics. My current understanding is the following:
Simple example to illustrate: Buy $1000 worth of AF stock with cash where the company’s Net A/L Position is $2000
Equity Method: Investment account (noncurrent asset) up $1000, Cash down $1000. What part of this transaction would be recorded in Equity? I thought only the Asset side of the balance sheet is affected? Do we not adjust cash down even though we disbursed it???
Proportionate Consolidation: All A+L up by 50% of AF’s A+L, 50% increase of their equity is included in your common Equity, so here I see the equity increase
Acquisition: All A+L of AF are consolidated, Only the Minority Interest is reported under equity??? We do not consolidate their equity otherwise (I know in 50/50 example would be same), but what if we owned 70%, just the 30% would be recorded in Equity? How would that balance?
I hope you feel better. To start out easy (won’t cause any migraines), how is the accounting side done for the Equity Method. Intuitively, I feel it would be cash down, investment account (noncurrent asset) up. What i’m seeing by looking at examples is that cash isn’t being affected but Equity is decreased and Investment account up. How is it possible that we are not reducing our cash when disbursing for the investment?
For the equity method, at acquisition, there is no change to the equity acount (as you said, cash goes down, investment goes up)
After year 1, for instance, the investment goes up by proportionate share of NI of the investee, minus dividends. However, cash will go up by the amount of the dividends. The net effect is that the assets have increased by the amount of proportionate income in the associate (or, your % ownership times the investee’s NI)
Shareholders equity OCI adjust by the amount of the share of net income - aggregated account. So, you are technically showing an unrealized gain in other comprehensive income.
Also for acquisition method, think about it this way. Key is to remember you consolidate all of the assets but also use capital to pay for it (which goes out the door to shareholders or whomever)
100% of assets are moved to the investors BS, and 100% of the liabilities. However, unless shareholders equity is zero, this causes the A = L + E to be out of balance. In addition - the investor has used capital to pay for their percentage ownership of the firm, for simplicity assume cash.
Simple example: acquired firm has 100 in assets, 70 in Liabilities and 30 in Equity (Net assets = 30).
They pay fair value for 2/3 of the company - pay 20 in cash for 66.6%.
Net effects:
Assets + 100 (minus 20 in cash for the acquired stock) so Assets = + 80
Liabilities = 70 total (no changes really)
Minority interest = 10 (which is 80 in assets - 70 in Liabs) OR 1/3 of the net assets of the firm (1/3 * 30)
This is exactly what I thought, however, various texts seem to cite that ROE would be the same for the Proportionate Consolidation and Equity Method which did not make sense to me. There is a specific example in the 2011 CFAI Mock Afternoon Session (#41 if you have this Mock) which substantiates that the ROE is identical for the two methods when comparing a company accounting for its investment via Proportionate Consolidation versus Equity Method. Is this an error?
Thanks Kwalew, this illustration makes it perfectly clear to me. I forgot to factor in the price paid going out the door which would offset and equity in the firm (net assets) which we acquired. The minority interest simply acts as balancer for the standard accounting equation and to keep the ratios consistent with the additional assets and liabilities we are showing. Perfect, many thanks
I think I see the error of my ways but would like confirmation. Proportionate consolidation does not adjust equity at all as I previously assumed, it only increases the Assets and Liabilities proportionately, the net asset difference being offset by the payment for the investment, whether it is via cash or stock. Can someone confirm?
Does anyone know with reading 22, Intercorporate Investments, Q12, if the reason for Net Income being the same is due to the minority interest net income being removed - and therefore both methods would be the same. Can someone confirm this for me?
Scatter, I confirm. The minority interest portion of the NI in the acquisition method is subtracted out, leaving you with the same impact of proportionate NI going to the bottom line as with the Equity/Proportionate Consolidation methods.
If the payment is via stock then net asset difference is not offset - there are no cash reduction in assets account. But there is equity increase by the amount of target net asset value (you issue new stock (equity goes up) and you use the proceeds to buy investment (assets go up).