Is Stephenson’s statement regarding the effect on profit margin correct?

Bryan Stephenson is an equity analyst and is developing a research report on Iberia Corporation at the request of his supervisor. Iberia is a conglomerate entity with significant corporate holdings in various industries. Specifically, Stephenson is interested in the effects of Iberia’s investments on its financial performance and has decided to focus on two investments: Midland Incorporated and Odessa Company.

Midland Incorporated

On December 31, 2007, Iberia purchased 5 million common shares of Midland Incorporated for 80 million. Midland has a total of 12.5 million common shares outstanding. The market value of Iberia’s investment in Midland was 89 million at the end of 2008 and 85 million at the end of 2009. For the year ended 2008, Midland reported net income of 30 million and paid dividends of 10 million. For the year ended 2009, Midland reported a loss of 5 million and paid dividends of 4 million.

During 2010, Midland sold goods to Iberia and reported 20% gross profit from the sale. Iberia sold all of the goods to a third party in 2010.

Odessa Company

On January 2, 2009, Iberia purchased 1 million common shares of Odessa Company as a long-term investment. The purchase price was 20 per share and on December 31, 2009, the market price of Odessa was 17 per share. The decline in value was considered temporary. For the year ended 2009, Odessa reported net income of 750 million and paid a dividend of 3 per share. Iberia considers its investment in Odessa as an investment in financial assets.

In addition, Iberia has a number of foreign investments, so Stephenson’s supervisor has asked him to draft a report on accounting methods and ratio analysis. The following are statements from Stephenson’s research report.

Statement 1: Under U.S. GAAP, firms are required to use proportionate consolidation to account for joint ventures.

Statement 2: In general, if the parent’s consolidated net income is positive, the equity method reports a higher net profit margin than the acquisition method.

Is Stephenson’s statement regarding the effect on profit margin correct?
A . Yes.
B . No. Net profit margin will be lower using the equity method.
C . No. Net profit margin will be the same using either the equity method or the acquisition method.

View Answer

Answer: A

Explanation:

In a profitable year, net profit margin (net income/sales) will be higher under the equity method because sales are lower under the equity method. Acquisition includes the sales figures for both the parent and subsidiary while the equity method only includes the sales figure for the parent company. Net income is the same under both methods. Therefore, the statement is correct. (Study Session 5, LOS 21.c)