| Ownership % | Influence | Method | Key Feature |
|---|---|---|---|
| <20% | Passive | Fair Value (FV) | No equity method; mark-to-market |
| 20–50% | Significant | Equity Method | Share of NI on I/S; investment adjusted on B/S |
|---|
| >50% | Control | Full Consolidation | 100% of all line items + Non-Controlling Interest |
|---|
| Joint Venture | Joint Control | Equity Method or Proportionate Consolidation | IFRS 11: equity method preferred |
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EQUITY METHOD FORMULA & MECHANICS
Carrying Value at Year-End:
$$\text{Ending Investment} = \text{Beginning} + \text{Share of NI} - \text{Dividends Received} - \text{Amortization of Excess}$$
Key Points:
- Income statement: Only one line—investor's share of NI (no visibility into revenue/expenses)
- Balance sheet: Investment shown as single asset, net of dividends
- Dividends = return of capital (NOT income)
- Excess FV over BV must be identified, allocated, and amortized
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CONSOLIDATION vs. EQUITY METHOD: RATIO EFFECTS
| Metric | Consolidation | Equity Method | Impact |
|---|---|---|---|
| Revenues | 100% of subsidiary | Parent only | Consolidation ↑ revenues |
|---|
| Assets | 100% of subsidiary assets | Single investment line | Consolidation ↑ assets, ↓ asset turnover |
|---|
| Net Income | After subsidiary amortization/depreciation | Share of NI only | May differ on amortization timing |
|---|
| Margins | Subsidiary expense embedded | Hidden (NI aggregated) | Consolidation more transparent to ratio distortion from PPA |
|---|
| Leverage | 100% of subsidiary debt | Off-balance-sheet | Consolidation shows true debt; equity method understates leverage |
|---|
→ Analyst Action: For equity method investments, proportionally consolidate (multiply by ownership %) to assess true economic leverage and asset base.
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PURCHASE PRICE ALLOCATION (PPA)
Goodwill = Acquisition Price − FV of Net Identifiable Assets
Post-Acquisition Effects on Financials:
- Depreciation/Amortization ↑: Step-up in PP&E, identifiable intangibles → lower EBITDA margins, lower NI
- Asset Base ↑: Return on Assets (ROA) reduced
- Goodwill ↑: Balance sheet larger (relevant for impairment testing)
Analyst Flag: Goodwill-heavy acquisitions signal overpayment risk. Compare goodwill % to synergy justification.
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GOODWILL IMPAIRMENT
| Aspect | US GAAP | IFRS |
|---|---|---|
| Amortization | NO (public co.) | NO |
|---|
| Testing Frequency | Annual (or triggering event) | Annual (or triggering event) |
|---|
| Impairment Calculation | Carrying value − Fair value of reporting unit | Recoverable amount test (higher of value-in-use / FV less costs) |
|---|
| Reversal | NOT permitted | NOT permitted for goodwill |
|---|
One-Step Impairment (US GAAP):
$$\text{Impairment Charge} = \text{Carrying Value} − \text{Fair Value (reporting unit)}, \text{ capped at goodwill}$$
Red Flag: Large impairment charges suggest management overpaid or synergies failed.
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VARIABLE INTEREST ENTITIES (VIEs) & CONSOLIDATION OVERRIDE
| Control Metric | US GAAP (ASC 810) | IFRS 10 |
|---|---|---|
| Criterion | Primary beneficiary absorbs majority of expected losses/returns OR has power to direct key decisions | Power over investee + exposure to variable returns + ability to use power to affect returns |
|---|
| Consolidation | Yes, by primary beneficiary | Yes, when control criteria met |
|---|
| Voting % | Irrelevant (can be <50%) | Irrelevant (can be <50%) |
|---|
Analyst Risk: Off-balance-sheet VIEs → understated leverage and overstated ROA. Always adjust for:
- Add VIE debt to parent debt
- Add VIE assets to parent assets
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NON-CONTROLLING INTEREST (NCI)
Definition: Minority equity stake in consolidated subsidiary
Financial Statement Placement:
- B/S: Separate line in equity section
- I/S: NCI in net income deducted from consolidated NI
Key Ratio Effect:
- Consolidated NI = Parent NI + NCI share − then NCI deducted
- Return to Parent Shareholders must exclude NCI income
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HIGH-YIELD DECISION TREE
``
Start: Company A holds equity in Company B
├─ Does A have >50% voting control?
│ ├─ YES → CONSOLIDATE (100% of B's items + NCI for minority)
│ └─ NO → Continue
│
├─ Does A have significant influence (20–50%) or management contracts?
│ ├─ YES → EQUITY METHOD (share of NI, investment on B/S)
│ ├─ Does A control B without voting (VIE/SPE)?
│ │ ├─ YES → CONSOLIDATE as primary beneficiary
│ │ └─ NO → Continue
│ └─ NO → Continue
│
└─ A has passive investment (<20% or no influence)
└─ FAIR VALUE METHOD (mark-to-market, no equity method)
``
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COMMON PITFALLS & EXAM TRAPS
| Trap | Correct Approach |
|---|---|
| Forgetting amortization of excess under equity method | Always extract excess FV, |