Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Seven – An introduction to consolidation
But what about cashflow models?
From the text it is clear that the equity (rather than proportionate, see below)
method of consolidation creates a strange outcome in group consolidated amounts.
Profit includes the share of profits from associates, but assets and liabilities are
netted off in the group balance sheet, which just shows a share of net assets. The
cash flow statement is even more unusual in that it excludes the associate, except
to the extent of dividends received from it. This means that analysts, when building
cash flow models of companies with associates, must often exclude the associate
completely from the analysis, and value the interest separately.
5.2 Proportionate Consolidation
As we saw earlier on in this chapter proportionate consolidation is a method of
combination that includes the investor share of each account caption. Therefore
the relationship is reflected in each income statement and balance sheet caption.
There is a reasonable argument that this overcomes a major shortcoming of the
equity method whereby the netting off procedure (i.e. reflecting a share of a net
number such as net assets or net income) can obfuscate useful information.
Proportional consolidation can be seen very much as a disaggregation process
and therefore provides significantly more information.
Analysis issues with proportional consolidation
As already mentioned, there is a strong school of thought that proportional
consolidation is superior to equity accounting due to the higher information flow
that investors receive. If that is the case why is proportional accounting
particularly rare – for example it is not used in the US save for specific industries
such as oil and gas? Not everyone would agree that proportional consolidation is
helpful for analysts. Two reasons are put forward for this. Firstly, proportional
consolidation includes items in net assets and income that are not under the
control of management. For example an investor would normally look at the
revenues number and analyse the marketing strength of a company on the
assumption that group management were in control of this number. But of course
if proportional consolidation was being used then a component of those revenues
are not under the control of management. Secondly, if proportional consolidation
is used then it is very difficult for analysts to reverse out the other entity as many
of the numbers are ‘tainted’. This reversal is particularly relevant when entities
undertaking materially different activities from the main group are proportionally
consolidated.
353