When a company takes a stake in another, it often has a choice of accounting policies. If a company is deemed to have significant influence, it will use the equity or one line consolidation method. If instead the company is considered to have control, the acquirer will consolidate the acquiree.
Under the equity method the acquirer’s proportionate share of the target company’s assets and liabilities will be disclosed in a single line on the acquirer’s balance sheet. The acquirer’s share of the acquiree’s profit is then disclosed as a single line on the acquirer’s income statement. If the acquiree generated £100m of income over the year and the acquirer had a 20% stake, the acquirer would record +£20m in its income statement. This method significantly distorts key financial ratios. Take the net margin ratio (net profit / revenue), this is likely to be overstated because we are including acquiree net profit without also including the proportionate share of revenue. If we assume the acquirer had £200m of revenue and £50m of net profit (25% margin) this extra profit would push the margin up to 35%.
If a company chooses to consolidate, the acquirer will essentially combine its own assets and liabilities with those of the acquiree, leaving assets and liabilities higher than if the equity method was used. The acquiree’s income statement is also combined with the parent’s on a line-by-line basis. Revenue and costs are included in proportion and so profit margins are not distorted. The choice of method can help to flatter various financial metrics which are used to assess company returns and balance sheet strength. Acquisition accounting should therefore be analysed carefully.