Evaluation of Proportion Consolidation Method as Well Equity Method - Essay Example

Financial Accounting Theory Part I Introduction A joint venture is “an entity in which the reporting entity holds an interest on long term basis and is jointly controlled by the reporting entity and one or more other venturers under a contractual agreement.” (Financial Reporting Standard 9) Further, IAS 31 requires “that the venturer should recognize in its financial statements the assets that it controls, the liabilities that it incurs, the expenses that it incurs, and its share of income from sale of goods or services by the joint venture. (IAS 31.18). Also International Accounting Standard 31 permits the accounting treat of investments in joint ventures in either of two methods, namely, the proportionate consolidation method or the equity method. It is matter of great controversy and discussion as which method is most suitable for venturer to recognize its joint venture interest in its financial statements. An effort has been made in this write up to suggest the most suitable method of accounting for the venturer. a) Proportionate consolidation method For applying proportionate consolidation method the consolidated financial statements of jointly controlled entity are used. The consolidated balance sheet of the venturer includes its share of assets that it controls jointly as well its share of liabilities for which it is jointly responsible. Similarly, the profit and loss account of the venturer includes its shares of income and expenses of the jointly controlled entity. IAS 31 suggests that this proportionate consolidation into the financial statement of the venturer may be made using either of two methods of presentation: First, Share in each asset, liability, income, and expenses of the venturer into the joint venture statements may be shown as separate line item under the asset, liability, income, and expenditure of similar nomenclature in the consolidated financial statements of the venturer, or the second, where the venturer may combine its share in each asset, liability, income, and expenditure into joint venture financial statement with asset, liability, income, and expenditure of similar nomenclature in the consolidated statements of venturer. Equity Method Under equity method initially the investment into the joint venture is recoded at cost. The venturer will recognize its share of joint venture income as an increase in investment and a corresponding increase in the net income. Share of income or part of investments actually withdrawn or taken from joint venture business is not shown as income by the venturer in its statements. Instead those are reported as reduction in the joint venture investment account. Market values of the investments into the joint venture are not considered. The transactions are recorded at cost only. When an investment in joint venture is sold, the equity method is applied up to the date of sale. A gain or loss is recognized equal to the difference between the carrying value of investment in joint venture and the sales proceeds. b) Evaluation of proportion consolidation method as well equity method: Proportionate consolidation method: This method recognizes the fact that the assets, liabilities, income and expenses are already recognized in the separate financial statements of the venturer. Consequently in the consolidated financial statements, no adjustments or other procedures are required in respect of these items when venturer presents consolidated financial statements. However this method suffers from certain deficiencies. Consistency principle of accountancy is defeated when proportionate consolidation method is used under conditions when reporting dates of entities are different. Proportionate consolidation method is deficient in case jointly controlled entities use accounting policies other than those adopted for consolidated financial statements for the like transaction and events in similar circumstances. Entities have to make appropriate adjustments while applying this method. Proportionate consolidation requires adjustments that result in offsetting any asset or liability by the deduction of other liability or asset or any income or expense by the deduction of other expense or income. It is inappropriate to set off assets, liabilities, income or expenses unless a legal right to set off exists and the offsetting represents the expectation as to the realization of the asset or settlement of liability. Equity Method: Equity method is traditionally applied under the circumstances where the venturer owns less than majority stake in joint venture but the venturer has the ability to exercise significant influence over the operating and financing policies of the joint venture business. This is generally assumed when the stake of the venturer is more than 20%, but not more than 50% of total stake in the joint venture. This basic advantage of using this method is the ease with which the transaction are recorded in the books of venturer, whereas under proportionate consolidation method, a whole lot of time consuming exercise is required to consolidate venturer’s financial statements. However, this method also suffers from certain limitations explained hereafter. When a joint venture investment is carried under the equity method, a recoverable from joint entity is not added to the investment account, but is separately recorded as receivable. Thus the basic purpose of venture represented by investment account is defeated, and a further exercise is required to find out book worth of joint venture investment. Under joint venture scheme, a venturer may make investment into the joint venture by acquiring preference capital. But the preferred stock is not accounted for under the equity method. Suggestions to IASB Each method has its advantages and disadvantages. But use of methods under different conditions and circumstances may sometime bring altogether unexpected results. As per Mark P. Baumen ‘Proponents of proportionate consolidation believe the equity method provides a distorted picture of firm profitability and risk by relegating details about investees’ balance sheet and income statement composition to the financial statement footnotes. For example, including its share of investee earnings in net income and understating the asset base used to generate these earnings overstates the investor’s return on assets. Similarly netting investee assets and liabilities in the investment account impacts leverage ratios, and shielding investee interest expense in the one- line presentation of investee income overstates interest coverage.” (Accounting Horizons, December 2003, page 305) Though it is true that all joint ventures are not similar in nature due to diversity and complexity of each joint venture arrangement; but as per David L. Reklau, “Pro rata consolidation clearly reflects the substantive difference between an investor’s involvement with joint ventures and other investees; equity does not adequately reflect results of operations and financial position when an investor has significant joint venture interests.” (The Journal of Accountancy, September 1977). Thus it is generally proved that proportionate consolidation method has superiority over equity method when assessment is made strictly from the point of view of accounting disclosures for the users of financial statements. But there is one more side of this controversial and much discussed subject. “Under Canadian Generally Accepted Accounting Principles (GAAP), firms are required to proportionally consolidate joint venture investments, as opposed to United States, where the equity method is used. Using a sample of Canadian firms, this study investigates the relative information content of equity method and proportionally consolidated financial statement amounts for explaining market risks. This is possible for Canadian firms where detailed footnote disclosures permit the calculations of pro forma equity method amounts. The findings are surprising in that whereas proportionally consolidated financial statements are more risk relevant than equity method statements for explaining price volatility, equity method statements are more risk relevant than proportionally consolidated ones for explaining bond ratings. The finding suggests that different market participant use financial statement information differently.” (Kazbi Kothavala, Nov-Dec 2003). Now this is clearly a revelation that disturbs all calculations in favour of ‘proportionate consolidation’ method. Under such circumstances and keeping in view the above facts, it may be stated that each method can work under circumstances and conditions that suits its performance. As IASB is making efforts to universalize the accountancy principle, it is suggested that IAS 31 should keep both option available for joint venture entities to decide which one is best for them. Part II a) Ratio Calculations b) Performance and financial strength assessment With reference to ratios calculated above, the performance of an entity can be assessed through Sales growth and Operating profit margin. On the other hand financial strength can be judged through Interest Cover, Current ratio, and Ratio of Liabilities to Assets. Accordingly the performance and financial strength of Diageo in comparison with that of its associates are assessed hereunder: Performance assessment Diageo has attained a sales growth of 2.19% in 2007 as compared to sales in 2006. Whereas the Diageo’s associates have performed much better than Diageo on this front. Their sales growth in 2007 is 6.54% over 2006. The sales growth of associates is rapid as compared to Diageo, and the reason for this may be the status of utilization of installed capacity. Associates have fewer sales in absolute figures as compared to Diageo. Associate might have started into the business later than Diageo and are having modern infra structure facilities as compared to Diageo. Further the unutilized capacity enabled the associated to grow more rapidly than Diageo. “The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock are deducted.” (Lawrence J. Gitman, 2006)Thus operating profit is the result of purely operating performances or for enacting main objectives of the entity. On this count also, the associates have a ratio of 29.8% as compared to 21.77% of Diageo. The sales growth as stated above would have played a major role in the better performance of the associates as compared to Diageo. Financial Strength Interest cover is also called ‘Times Interest Earned Ratio’. It basically conveys the ability of the entity to meet the fixed interest payment liabilities. The Diageo has this ability of meeting the fixed interest payments 5.96 times when its interest liability is compared with earning before taxes and interest. On the other hand the associates have tremendous ability of 19.42 times of meeting fixed interest liabilities. All this has happened because of tremendous growth in sales of the associates during 2007, that gave them a exceptionally good operational profits. That is the reason their interest cover is much better than that of Diageo. Current ratio is the test of liquidity for any entity. It is considered that ratio of 2 is the general standard, where any firm can meet its current liabilities as they come. However, this standard differs from industry to industry. From this point of view Diageo has the lowest ratio of 1.24 as compared to 1.82 of its associates other than ‘Moet Hennessy’, whose current ratio is fantastic 2.79. That means Diageo may find it difficult to meet its current obligation, where as the position of other associates is not comfortable but better than Diageo. But Moet Hennessy is really stronger from liquidity point of view. A total liability to total assets ratio conveys the strength of total assets in comparison with total liabilities of an entity. In case of Diageo its total liabilities are 0.7 of its total assets. Whereas this ratio is 0.36 in case of other associates and 0.32 for Moet Hennessy. Accordingly the position of Moet Hennessy is very strong so far its assets are concerned in comparison to its total liabilities. Its assets can meet its total liabilities much easier than other associates and Diageo. The position of other associates is also strong and near to Moet Hennessy. But Diageo is again found at deplorable position when compared with others. Overall performance Performance, liquidity, and financial strength of the associates are far ahead of Diageo. They can face any financial eventuality. Whereas, the position of Diageo is precarious as compared to other associates and Moet Hennessy. The liquidity position of Diageo is risky and need an immediate improvement, if it has to meet its current obligations very timely. Also Diageo should put efforts to improve its total assets position through restructuring its infra structure. Reference: David L.Raklau, Accounting for investments in Joint Ventures- A reexamination, the journal of Accountancy, September 1977, page 102, http://academia-research.com/files/message/733548_D%20Reklau%20%20Journal%20of%20Accountancy.pdf Financial Reporting Standard 9, Associates and Joint Ventures, issued by Accounting Standards Board, page 17, http://www.frc.org.uk/images/uploaded/documents/09%20-%20Associates%20and%20Joint%20Ventures.pdf IAS Plus International Accounting Standard 31, Summaries of International Financial Reporting Standards,, Interests in Joint Ventures, IAS 31.18, viewed on March 19, 2008, http://www.iasplus.com/standard/ias31.htm Kazbi Kothavala, Journal of Accounting and Pubic Policy, Nov.-Dec. 2003, Abstract, http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VBG-4B2901W-1&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&view=c&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=9d439c8be7fc99fb2355018ca45e29ce Lawrence J. Gitman, Principles of Managerial Finance, Eleventh Edition, 2006, Chapter 2, page 67. Mark P. Baumen, The impact and valuation of off- Balance-Sheet Activities concealed by Equity Method Accounting, Accounting Horizons, Vol. 17, No. 4, December 2003, page 305. Read More