Full Consolidation: The Acquisition Method [CFA Level 2 Notes #33]

OK so — how does the consolidation the standards actually recognize work? It’s the thing called "(Full) Consolidation by the Acquisition Method."

Combined balance sheet at the acquisition: A’s investment in subsidiary of 400 is crossed out, all of B’s assets (1,000) and liabilities (500) come in, and NCI of 100 (500 x 20%) sits next to A’s equity of 1,000

Instead of pulling in assets and liabilities in proportion to your ownership stake, you wipe out the investment-in-subsidiary line and just yank in everything — all of B’s assets, all of B’s liabilities. Just pull it all in!

But… if you grab 100%, the balance sheet obviously won’t balance, right? Bringing in 100% of B’s assets and liabilities means you’ve also brought in 100% of B’s net assets.

So how do you make it balance?

You pull in 100% first, and then the slice that isn’t actually yours gets shoved into equity as Non-Controlling Interest. Bam — balanced.

Honestly, common-sensically, proportionate consolidation — where you only pull in your own ownership slice — kinda sounds like the more reasonable method, no?

So why on earth — whether US-GAAP or IFRS — did they pick Full Consolidation as the standard…?

Think about it in terms of actual physical stuff, though, and full consolidation will probably feel more right. Say the company I control is Hyundai Motor. If you proportionately-consolidate it, each car gets sliced at 80% — that part is mine; each machine that builds the cars gets sliced at 80% — that part is mine; snip snip snip, everything gets sliced and “this much is mine!!” — that’s the financial statement you’d get.

Sketch of a consolidated balance sheet: the asset side says mine, yours, use it all; the other side lists the claims on them, claim by claim

But acquisition-method consolidation says: “nah, just use all of theirs for now~~, and then on top of that, list out who has a claim on what.” You’d think that’s the more self-evident view…

OK so, up to this point we’ve got the methods that describe relationships between companies. Line up the three: equity method vs. proportionate consolidation vs. consolidation.

Which one comes out with the biggest size?!?!

→ Consolidation, obviously!! You’re not slicing and bringing in, you’re bringing it in whole — and not only the assets and liabilities: equity is also biggest under consolidation, because NCI is sitting in there. Let’s eyeball a comparison.

The same deal three ways: under the equity method one investment line of 400; under proportionate consolidation 80% of B’s assets (800) and liabilities (400); under consolidation all of B’s 1,000 and 500 plus NCI of 100

For this positive-profit example, keep the numerator fixed at income attributable to A’s owners. More assets then means a smaller return-on-assets ratio: equity method > proportionate consolidation > full consolidation. But don’t turn that into a universal ranking! For owners’ ROE, pair A’s owners’ income with A’s owners’ equity, excluding NCI from both; that ROE stays the same here.

(they might ask about this kind of comparison)

Quick history detour: before Korea adopted IFRS in 2011, a parent’s main financial statements didn’t consolidate its subsidiaries — they carried them with the equity method. When consolidated financial statements became the primary statements, the reported scale and some ratios changed even though the underlying business hadn’t suddenly changed. The direction isn’t universal — it depends on the subsidiary’s results and on how the ratio is defined.

OK now let’s also look at consolidation on the income side. Same vibe — you bring in 100% of everything first, and then at the bottom you peel off the slice that isn’t yours, like so.

Consolidated income statement in the CFA layout: revenue 2,000 of A and 1,000 of B, expenses (1,500) and (800), NCI (40), net income 660

Out of B’s profit of 200, you peel off 20% as not-mine (net income attributable to non-controlling interest). The not-mine deduction is the same as in the other methods, so the bottom-line number ends up identical.

And since the leftover is what belongs to A’s shareholders, we call it “net income attributable to controlling interest.”

Now that we’ve got the rough picture, let’s summarize the I/S impact across the three treatments:

Revenue: equity method < proportionate consolidation < consolidation
|Expenses|: equity method < proportionate consolidation < consolidation
Income (A’s share): equity method = proportionate consolidation = consolidation

In this simplified comparison, income attributable to A’s owners comes out equal~ Total consolidated net income also includes the NCI’s share; we’ll split those out below.

ROE, ROA and net profit margin under the three methods: net income is the same, equity and assets grow from the equity method to proportionate to full consolidation, so ROE ties for the first two and is lowest under consolidation, and ROA and the margin fall step by step

OK let’s run the year-end consolidation all the way through and close it out.

Year-end consolidated balance sheet: assets 2,100 of A and 1,200 of B, liabilities 1,000 and 500, A’s equity 1,000, retained earnings 500 + 160, NCI 140

➀ In the consolidated B/S at the start of x1, R/E was zero, and looking at the I/S, the net income attributable to controlling interest is what flows into A’s consolidated R/E. Tracks. So at end of x1, A’s consolidated R/E = 0 + 660 = 660. NCI was 100 at the start, then during the period net income attributable to non-controlling interest of 40 piled on, so ending NCI = 100 + 40.

Approach ➀ is the logic of “beginning consolidated B/S of x1 + consolidated I/S of x1 ⇒ ending consolidated B/S of x1.” You also need to be able to derive it using approach ➁: “A’s end-of-x1 separate + B’s end-of-x1 separate ⇒ ending consolidated B/S.”

The same year-end balance sheet with notes: both year-end balance sheets come in whole, A’s own lines go in 100%, only 80% of B’s earnings (160) is added to retained earnings, and NCI is 20% of B’s equity of 700, i.e. 140

Curriculum quiz: Company M buys 20% of Company N for 6 million dollars on January 1, 2017; N reports a 2017 net loss of 450,000 dollars and dividends of 600,000 dollars

Working for the quiz: the carrying value is 6,000,000 minus 20% of the 450,000 loss minus 20% of the 600,000 dividends, 5,790,000 dollars; the income question asks for the same 90,000 dollar loss again

Curriculum quiz: P buys 80% of S for 120,000 dollars cash on December 31, 2016, with the pre-acquisition balance sheets and the 2017 income statements of both

Working: total assets right after the deal 1,440,000 dollars, exam-basis consolidated net income 348,000 dollars, and minority interest of 39,000 dollars worked out two ways

Curriculum quiz: Company C owns 50% of the joint venture JVC and uses the equity method; 2017 balance sheets and income statements of C and JVC

Working: under the acquisition method equity is 6,350 and total assets 17,450; under proportionate consolidation cost of goods sold is 8,000 and net income does not change

Now the moment of truth..

If you actually pop into DART and open up a real set of consolidated financial statements — are they written the way we saw above?

The CFA-style layout takes NCI off above net income; the note says the current standard never does that, because the NCI’s share would then look like an expense

The current-standard layout: net income first, then split between the controlling and the non-controlling interest; real consolidated net income includes the NCI’s share

Here’s a real one, Samsung Electronics’ consolidated income statement for Q1 2022 on DART: it ends with net income of 11,324,628 million won, and right under it splits that into 11,129,094 attributable to owners of the parent and 195,534 attributable to non-controlling interests. Exactly that layout!

OK story time — the real-brain use case of the equity method vs. proportionate consolidation.. (this one gives me chills..)

Earlier I mentioned Joint Ventures briefly — “just slap equity method on it..” — that was about it, and we moved on. But for setups like this, the actual ownership percentage isn’t really the thing that matters.. because even when the percentages are uneven, you’ll see lots of deals along the lines of: “when it comes to decision-making, it’s 5:5!”

Key East and JYP put money into a joint venture (an SPC): under the equity method its result lands below Key East’s operating income; under proportionate consolidation it comes in above it

OK so. Back in the day, Key East — an entertainment company — and JYP set up a JV and shot a drama. At that point, Key East’s separate financials were in their 4th straight year of operating losses. Then this drama became an absolute megahit, right? (None other than “Dream High.”) Oh sweet, saved! …or so you’d think?

Nope. Not at all. If you apply equity method accounting, equity-method income gets parked as non-operating income, below the operating line, so they were stuck — no way around a 4th straight year of operating losses..

Back then, IAS 31 allowed proportionate consolidation for jointly controlled entities. This is a historical story: current IFRS 11 generally requires the equity method for joint ventures, so this isn’t a choice you can simply make today.

And if you use proportionate consolidation, you pull in everything proportionately starting from revenue, so you can actually swing the operating line into the black…

Key East’s CEO at the time happened to have an accountant background, flipped his thinking in this exact direction, and — apparently — that’s how they dodged delisting.. A real-deal Brain.. shivers

Heads-up. The figures here are the original notes, slips and all. A few things to watch for:

The ratio chart holds the positive parent-attributable profit numerator fixed. For a consistent owners’ ROE, exclude NCI from both income and equity; using parent profit over total equity would mix two different ownership scopes. The acquisition-method JV quiz is a hypothetical comparison, not permission to consolidate a jointly controlled venture as a subsidiary.

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