In Studying the Impact of Consolidation on Price/Earnings (P/E) Ratios $\bullet$

question 11

Essay

In studying the impact of consolidation on Price/Earnings (P/E) ratios, there are four basic methods of consolidating the account of a subsidiary into the parent company:
$\bullet$ Full consolidation. Assets, liabilities, and earnings of the subsidiaries are fully incorporated,
line-by-line, into the parent's accounts, with special care to avoid double counting.
$\bullet$ Proportional consolidation. Assets, liabilities, and earnings are consolidated line-by-line, proportionate to the percentage of ownership in the subsidiary.
$\bullet$ Equity consolidation. A share of the subsidiary profits is consolidated on a one-line basis, proportionate to the share of equity owned by the parent. The value of the investment in the subsidiary is adjusted to reflect the change in the subsidiary's equity.
$\bullet$ No consolidation. This is sometimes referred to as the cost method, whereby only dividends received from the subsidiary affect earnings of the parent. The value of the investment in the subsidiary is carried at cost in the parent's book and is not revalued.
Here are the simplified 2000 accounts of Papa SA and Fille SA, two French firms. Papa SA owns 50% of Fille SA, a company created the previous year. Fille SA has not paid any dividend. The nonconsolidated accounts follow:
$$\begin{array} { l c c } & \begin{array} { c } \text { Papa SA } \\\text { E million }\end{array} & \begin{array} { c } \text { Fille SA } \\\text { E million }\end{array} \\\hline \text { Falance Sheets, End-2000 } & & \\\text { Fixed Assets } & 400 & \text { 80 } \\\text { Investment in Subsidiary } & 50 & \\\text { Current Assets } & \underline {50 }& \underline { 40 } \\\text { Total Assets } & 500 & 120 \\\text { Share Capital } & 440 & 100 \\\text { Net Income 2000 } & \underline {60} &\underline { 20} \\\hline\end{array}$$ Continued
$\begin{array}{c}\begin{array}{lll}\\\\ \hline \text { Stockholders Equity }\\ \text { Minority Interests}\\ \text { Total Liabilities}\\ \text { Income Statement 2000}\\ \text { Revenues}\\ \text { Expenses}\\\\ \text { Income from Subsidiary}\\ \text { Minority Interests (-)}\\ \text { Net Income}\end{array}\begin{array}{lll} \text {Papa SA}\\ \text { € million}\\ \hline 500\\--\\500\\\\300\\\underline{240}\\60\\\\--\\60\end{array}\begin{array}{lll} \text {Fille SA}\\ \text { € million}\\ \hline 120\\--\\120\\\\80\\\underline{60}\\20\\\\--\\20\end{array}\end{array}$
The nonconsolidated accounts for Papa SA use the cost method, whereby the investment in the subsidiary is carried at historical cost in the balance sheet of the parent.
a. Establish the consolidated accounts, using the other three methods outlined above.
b. Which method provides the highest reported net income for Papa SA?
c. Which method provides the highest P/E ratio, based on book value, for Papa SA?

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Definitions:

Direct Materials

Raw materials that are directly traceable to the production of a specific product, representing a significant portion of the costs of goods sold.

Variable Overhead Rate Variance

The difference between the actual variable overhead costs incurred and the expected costs based on the predetermined overhead rate.

Direct Materials

Raw materials that are directly traceable and allocable to the production of specific goods or services.

Raw Materials Price Variance

The difference between the actual cost of raw materials and the standard cost multiplied by the actual quantity used.