FINANCIAL RATIOS

Financial Ratios

Financial Ratios

INTRODUCTION

Financial analysts have long been concerned with the effect of off-balance-sheet activities on a firm's financial condition. The financial statement analysis literature emphasizes the importance of examining footnote disclosures for the existence of economic assets and liabilities that are not recognized under generally accepted accounting principles (GAAP); Lasman and Weil (1978) provide an early example. Further, off-balance-sheet activities receive increased attention in the post-Enron world (Marshall 1992).

This paper examines financial analysis and valuation issues caused by off-balance-sheet activities that are not fully reported under equity method accounting. Described in Accounting Principles Board (APB) Opinion No. 18 (APB No. 18, APB 1971), investors must use the equity method for investments in common stock that provide "significant influence over operating and financial policies of an investee even though the investor holds 50% or less of the voting stock" (APB No. 18, [paragraph] 17). There is a presumption that significant influence exists with ownership interests of 20 percent.

Discussion

Given that GAAP requires the equity method, in analysis a key issue is how to best reflect the investment in the investor's financial statements. In most cases, the equity method summarizes the investor's share of the investee's net assets and net income in single lines in the balance sheet and income statement, respectively. An alternative approach consolidates the components of the investee's assets, liabilities, and income with those of the investor. Another alternative approach consolidates only the investor's proportionate share of the components of the investee's assets, liabilities, and income. These alternative approaches can produce large differences in the investor's reported performance and leverage. (Marshall 1992).

The equity method of accounting is controversial. Fabozzi (1995) performs a critical analysis of the accounting for significant influence equity investments, defined as "situations where one entity possesses more than a passive investment in another entity but does not control that entity." (Fabozzi,1995,225)They develop two conclusions based on financial analysis considerations, consolidation theory, and aggregation issues. First, they find "no substantive justification for continued use of the equity method due to the method's intrinsically limited informational characteristics" (Stigum and Mann,1981,281). Second, they recommend alternative accounting methods--proportionate consolidation and the expanded equity method. Proportionate consolidation and the expanded equity method are substantially similar, differing only in presentation format. For purposes of this paper, I consider these methods equivalent.

Proportionate consolidation is common outside the United States. International Accounting Standard No. 31 (International Accounting Standards Board [IASB] 1990) recommends proportionate consolidation for ...