Key Difference – Proportionate Consolidation vs Equity Method
Companies make investments in other companies for a variety of strategic and operational reasons. These types of investments bring economic benefits that should be reflected in the company’s financial statements to facilitate better decision-making ability for the users of financial statements. Proportionate consolidation and equity method are two ways that companies use to reflect their investments in other entities in financial accounts. The key difference between proportionate consolidation and equity method is that while proportionate consolidation method records the portion of ownership in the investment by recording the shares of assets, liabilities, incomes and expenses of the investment company in the financial records, equity method records the initial investment at the time of acquisition and the changes to investment value is recorded going forward.
CONTENTS
1. Overview and Key Difference
2. What is Proportionate Consolidation
3. What is Equity Method
4. Side by Side Comparison – Proportionate Consolidation vs Equity Method
5. Summary
What is Proportionate Consolidation
Proportionate consolidation is a method of including items of income, expense, assets and liabilities in proportion to the company’s percentage of ownership in the investment company. The proportionate consolidation method was initially favored by IFRS accounting standards, though it also allows the use of the equity method.
E.g. ABC Ltd. acquires a share of 40% in DFE Ltd. DEF makes a gross profit of $3500 by selling goods worth of $7,450. So, the cost of sales is $3,950.
Following is an extract of the income statement of ABC Ltd where 40% of the results of DEF Ltd. are incorporated into the results of ABC Ltd.
This method is preferred by many investors as it provides detailed information on the performance of the investment company by reflecting its shares of assets, liabilities, incomes and expenses separately.
What is Equity Method
The equity method is an accounting technique used by companies to assess the profits earned by their investments in other companies; here the parent company does not have control but exerts significant influence. In other words, the shareholding of the investment company is between 20%-50%.
When the equity method is used to account for ownership in a company, the investor records the initial investment in the stock at cost and that value is periodically adjusted to reflect the changes in value resulting from the investor’s share in the company’s profit or loss. The assets and the liabilities of the investment company are not recorded in the accounts of the parent.
Steps in Accounting for Investments Using Equity Method
- Record the Initial Investment
When a parent company makes an investment in another company the latter is referred to as ‘investment in affiliate’ in the records of the parent.
E.g. BCD Ltd purchases a share of 35% in HIJ Ltd for $50,000. It will be recorded as,
Investment in affiliate DR$50,000
Cash CR$50,000
- Record the Equity Income
The parent company is entitled to a portion of profits in the investment company. When this is earned, it will be recorded as an increase in investment in affiliate. Continuing from the same example,
E.g. Assume HIJ made a profit of $7,500 for the latest financial year and BCD’s share of profit is $2,625 ($7,500* 35%).
Investment in affiliate DR$2,625
Equity income in affiliate CR$2,625
- Record the Cash Dividend
The profits may be distributed as cash dividends or retained for future utilization. Assume that HIJ declares $2,000 as cash dividend. $700 ($2,000* 35%) belongs to BCD. The dividend will be recorded as,
Cash DR$700
Investment in affiliate CR$700
Equity method is a simpler and more convenient way of recording share of investments compared to proportionate consolidation method.
Figure 1: Recording criteria of investment company in Equity Method
What is the difference between Proportionate Consolidation and Equity Method?
Proportionate Consolidation vs Equity Method |
|
| This method records the portion of ownership in the investment by recording the shares of assets, liabilities, incomes and expenses of the investment company in the financial records. | Initial investment is recorded at the time of acquisition and the changes to investment value are recorded going forward. |
| Components | |
| Investment’s assets, liabilities, incomes, and expenses are recorded line by line in the accounts of the parent. | Only the changes to the initial investment (E.g. Profits, cash dividends) are recorded in Equity method. |
| Usage | |
| This is a detailed method of reporting results of investment companies. | Equity method is a simpler way of reporting results of investment companies. |
Summary – Proportionate Consolidation vs Equity Method
The difference between proportionate consolidation and equity method is mainly attributed to the way results of the investment company are incorporated into the financial statements of the parent. Accounting standards give the freedom to companies to follow whichever preferred method; however, equity method is the widely used one.
Reference:
1.”Equity Method.” Investopedia. N.p., 19 June 2015. Web. 28 Feb. 2017.
2.”Equity Method Accounting.” Equity Method Accounting. N.p., n.d. Web. 01 Mar. 2017.
3.”Proportional Consolidation.” Investopedia. N.p., 14 Aug. 2010. Web. 01 Mar. 2017.
4.”Consolidation and equity method of accounting – PwC.” N.p., n.d. Web. 1 Mar. 2017.