Adjusting Net Income for Unconsolidated Affiliates
Our article on equity income from affiliates described the income statement treatment for investments a company makes that result in it owning a significant amount of the investee, but not enough to treat it as a subsidiary. In accounting for business combinations we showed what can happen when companies report similar investments using different accounting methods. What follows is an excerpt from an article originally posted at Stock Market Beat discussing generally how to analyze the income statement of a company that has unconsolidated affiliates.
Xerox’ participation in the Fuji Xerox JV is accounted for using what is known as the equity method. According to the company’s latest 10K, “Equity in net income of unconsolidated affiliates of $114 million, principally related to our 25% share of Fuji Xerox income, which increased by $16 million in 2006 as compared to 2005, primarily due to improved operational performance.” In both 2005 and 2006 the Fuji Xerox venture contributed nearly 10% of the net income reported by Xerox, without muddying up the “revenue” or “expense” lines.
It is a simple adjustment, however, to see how net margin would be affected by looking at only the operations for which Xerox fully reports results. All that is needed is to subtract “equity in net income of unconsolidated affiliates” from net income, which we do in the table below.
As expected, net margin is lower when you take out portions that are treated as 100% profit (all costs are off the financial statements.) There is also a smaller improvement in margin (130 basis points rather than the 140 reported) in 2006, but a larger one in 2005 when adjusted numbers are used. In addition, the growth in net income is higher in both periods when using the adjusted number. Overall, this analysis tells us that the company’s non-JV business was starting in worse condition that was apparent, but showed more significant improvement relative to taking the numbers at face value.
By understanding how the accounting requirements as well as any management discretion used when applying them, investors can piece together more of the puzzle.
For more information, see all articles on: Accounting, Adjusting Reported Financial Statements, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
