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International Review of Financial Analysis 16 (2007) 496 507

Proportionate consolidation versus the equity method: Additional evidence on the association with bond ratings
Mark P. Bauman
College of Business Administration, University of Northern Iowa, Cedar Falls, IA 50614, United States Available online 23 June 2007

Abstract From a financial analysis perspective, proportionate consolidation of significant influence equity investments is often presumed to provide more useful information than equity method accounting. Surprisingly, Kothavala [Kothavala, K., 2003, Proportional consolidation versus the equity method: A risk measurement perspective on reporting interests in joint ventures, Journal of Accounting and Public Policy 22, 517538.] finds that financial statement measures based on the equity method are more relevant for bond ratings than are similar measures based on proportionate consolidation. This study provides additional evidence regarding this issue. Using a sample of manufacturing firms with significant influence equity investments accounted for under U.S. GAAP, the results indicate that pro forma proportionately consolidated financial statements have greater relevance than equity method statements for explaining bond ratings. 2007 Elsevier Inc. All rights reserved.
JEL classification: G10; M41 Keywords: Bond ratings; Accounting methods

1. Introduction The accounting for significant influence equity investments is interesting due to the diversity observed in practice. For example, while the IASB recommends and Canada requires

I thank Chris Bauman, Ken Shaw, an anonymous reviewer, and the editor for their helpful comments and suggestions. I also thank Donald Cram for generously providing SAS code for a logit-based likelihood ratio test. Tel.: +1 319 273 4323; fax: +1 319 273 2922. E-mail address: mark.bauman@uni.edu.

1057-5219/$ - see front matter 2007 Elsevier Inc. All rights reserved. doi:10.1016/j.irfa.2007.06.005

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proportionate consolidation for joint venture investments, U.S. GAAP requires the equity method of accounting.1 Under the equity method, a significant influence equity investment is reflected in the investor's financial statements as single lines in the balance sheet and income statement. This presentation of net amounts is criticized as a means of facilitating off-balance sheet activities and potentially hindering effective financial analysis (e.g., Penman, 2004; Stickney & Brown, 1999; White, Sondhi, & Fried, 2003). Under proportionate consolidation, the investor combines on a line-byline basis its accounts with its pro rata share of the investee's accounts. Accordingly, proportionate consolidation provides a more comprehensive view of the investor's operations and financial condition. Research has examined various aspects of credit analysis (e.g., Carleton, Dragun, & Lazear, 1993; Laitinen, 1999) and the differences between financial statements prepared under proportionate consolidation versus the equity method (see Kothavala (2003) for a detailed summary). Bierman (1992) argues that proportionate consolidation is superior and should be used for all material equity investments, even majority-owned subsidiaries. Davis and Largay (1999, p. 281) find no substantive justification for continued use of the equity methoddue to the method's intrinsically limited informational characteristics. Graham, King, and Morrill (2003) find that financial statements prepared under proportionate consolidation provide better predictions of future profitability than pro forma statements prepared under the equity method. Not all studies find in favor of proportionate consolidation. Using a sample of Canadian firms, Kothavala (2003) finds that equity method statements are more relevant for bond ratings than are proportionately consolidated statements. Stoltzfus and Epps (2005) find that financial statements prepared under proportionate consolidation are more strongly associated with bond risk premiums than equity method statements only for firms that guarantee the debt of joint venture investments. In the current study, I use a sample of U.S. manufacturing firms to examine further the relative information content of proportionately consolidated versus equity method financial statement amounts for explaining bond ratings. In contrast to Kothavala (2003), the results indicate that proportionately consolidated financial statements have greater relevance than equity method statements for explaining bond ratings. These differing results are most likely due to homogeneity of the sample firms in the present study. Unlike Stoltzfus and Epps (2005), the results are not altered when guarantees of investee obligations are considered. Overall, these results add to the ongoing debate regarding the usefulness of financial statements prepared under alternative methods of accounting for significant influence equity investments. The remainder of the paper proceeds as follows. Section 2 presents the research design. Section 3 describes the data and results. Section 4 concludes. 2. Research design The empirical analysis proceeds in three steps. First, I estimate the models employed by Kothavala (2003), using the same variable definitions. In particular, financial statement measures

As described in Accounting Principles Board (APB) Opinion 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 18, 17). There is a presumption that significant influence exists with ownership interests of 20% or more.

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based on amounts determined under equity method (E) and proportionate consolidation (P) accounting are separately regressed against bond ratings: E RATINGit a0 a1 TAEit a2 LEVEit a3 ROAEit a4 SRAEit a5 PMEit a6 VREit eit P RATINGit b0 b1 TAPit b2 LEVPit b3 ROAPit b4 SRAPit b5 PMPit b6 VRPit eit ; 1

where RATING is the Standard & Poor's long-term issuer credit rating. A rating of AAA is assigned a value of 1 and a rating of D is assigned a value of 22.2 The independent variables are measured as follows: TA is the natural logarithm of total assets, LEV is total liabilities divided by the book value of common equity, ROA is return on assets (calculated as net income divided by ending total assets), SRA is the standard deviation of ROA, PM is profit margin (net income divided by total revenues), and VR is revenue volatility (calculated as the standard deviation of total revenues scaled by the book value of common equity). The coefficients on TA and ROA are expected to be negative, as credit risk should be decreasing in firm size and profitability. Conversely, as credit risk is increasing in leverage and volatility, the coefficients on LEV, SRA, and VR are expected to be positive. With respect to profit margin, Kothavala (2003) states that the coefficient on PM should be negative (i.e., profit margin inversely related to risk). However, one must recognize that the ROA term is equal to the product of PM and asset turnover (ATO, where ATO = total revenues total assets). Given ROA represents the interaction between PM and ATO, the marginal effect of PM on RATING is appropriately measured as 3ATO + 5 and 3ATO + 5 in Eqs. (1) and (2), respectively. While the marginal effect of PM on RATING should be negative, there is no clear prediction for the coefficient on the PM term itself. Eqs. (1) and (2) are estimated via OLS regression, and the test of relative information content from Biddle, Seow, and Siegel (1995) (BBS) is used to compare the two competing, non-nested models. Thus, the focus is on relative explanatory power of financial statement measures based on the equity method versus proportionate consolidation. The next step of the empirical analysis involves two modifications to Eqs. (1) and (2). First, I substitute the market value of equity for book value of equity in the VR term. As VR is designed to measure the volatility of (scaled) revenues, the coefficient should be positive. However, the coefficient estimates in Kothavala (2003) are negative. A likely cause of this unexpected result is a small denominator problem associated with scaling by book value of equity. For consistency, the market value of equity is also substituted for book value of equity in the leverage term (LEV). Second, the models do not include guarantees of investee obligations made by investors. As acknowledged by Kothavala (2003), it is unlikely that bond raters ignore these contingent liabilities; however, specific details on guarantees are often not available in financial statements. Further, Stoltzfus and Epps (2005) find that the existence of guarantees affects the relative explanatory power (for bond risk premiums) of proportionately consolidated versus equity method statements. Thus, Kothavala's finding that equity method statements are more relevant for bond ratings than are proportionately consolidated statements may be due to her sample not including many firms that provide such guarantees. In the current study, many sample firms
RATING ranges from 1 to 27 in Kothavala (2003). This difference is due to the lack of +/ modifiers in Compustat for bond ratings of CC and C. However, there are no firms with ratings below CCC in the current sample.
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disclose guarantees related to investee obligations. Although the precise dollar amount of some commitments (e.g., formal guarantee of a credit facility) can be identified, others (e.g., deficiency agreements, take-or-pay contracts, etc.) cannot be accurately quantified. Accordingly, the existence of guarantees enters the revised models in the form of an indicator variable, GUAR, set equal to 1 if the firm discloses some form of guarantee (and equal to 0 otherwise): E RATINGit a0 a1 TAEit a2 LEVMEit a3 ROAEit a4 SRAEit a5 PMEit a6 VRMEit a7 GUAR eit P RATINGit b0 b1 TAPit b2 LEVMPit b3 ROAPit b4 SRAPit b5 PMPit b6 VRMPit b7 GUAR eit ; 10

20

where LEVM is total liabilities divided by the market value of common equity, VRM is the standard deviation of total revenues scaled by the market value of common equity, and all other variables are as defined above. As the existence of guarantees increases the level of risk, it is expected that GUAR will have a positive coefficient.3 If the inclusion of GUAR increases the information content of one model relative to the other, any difference in explanatory power from estimating Eqs. (1) and (2) may be affected. Finally, there is a problem using the OLS estimator with bond ratings as the dependent variable. OLS assumes that bond ratings are measured on an interval scale, such that the ratings represent equal intervals on a scale of creditworthiness. However, bond ratings convey ordinal information (Kaplan & Urwitz, 1979; Kennedy, 1998). To address the possibility of misspecification, Eqs. (1) and (2) are estimated using an ordered logit model. The logit-based test of relative information content from Hillegeist et al. (1995) is then used to compare the two competing models.4 3. Data and results 3.1. Data and descriptive statistics To be included in the sample, a firm must (1) be a calendar year-end U.S. manufacturing firm (SIC code between 2000 and 3999), (2) have non-missing, non-zero amounts for Equity in Earnings (Compustat item #55), (3) have Standard & Poor's issuer debt ratings reported on Compustat (item #280), and (4) provide footnote disclosures in sufficient detail to permit pro forma proportionate consolidation of equity method investees.5 An example of pro forma proportionate consolidation of an equity method investee is provided in the Appendix. Limiting the sample to manufacturers increases the degree of homogeneity among firms, allowing for more valid comparisons of ratio values. After deleting observations with negative book values, the final sample consists of 39 firms and 173 firm-year observations from 1997 2001. The sample is similar in size to that used by Kothavala (2003) 40 firms and 156 firmyear observations from 19952000.
3 Recall that GUAR represents guarantees made by the investor company with respect to obligations of the investee. Thus, the credit risk of the investor is increasing in the presence of such guarantees. 4 The test is a logit-based version of the Vuong (1989) test, designed to statistically compare the log likelihood statistics of non-nested models. 5 SEC regulations require detailed footnote disclosure only when one of three specific materiality thresholds is met.

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Table 1 Descriptive statistics (N = 173) Variable RATING TAE TAP LEVE LEVP LEVME LEVMP ROAE ROAP SRAE SRAP PME PMP VRE VRP VRME VRMP GUAR Mean 9.271 8.542 8.650 3.853 4.514 1.307 1.528 0.036 0.033 0.045 0.038 0.040 0.033 1.619 1.869 0.614 0.698 0.301 Median 9.000 8.374 8.417 1.889 2.269 0.878 0.967 0.043 0.039 0.033 0.030 0.051 0.045 0.405 0.464 0.272 0.309 0 S.D. 4.07 1.32 1.33 8.53 9.68 1.29 1.55 0.07 0.06 0.04 0.03 0.08 0.07 4.54 5.23 0.75 0.79 0.46 Wilcoxon b0.01 b0.01 b0.01 b0.01 b0.01 b0.01 b0.01 b0.01

RATING is the S&P long-term issuer credit rating (a rating of AAA is assigned a value of 1 and a rating of D is assigned a value of 22), LEV is total liabilities divided by the book value of common equity, LEVM is total liabilities divided by the market value of common equity, ROA is return on assets (calculated as net income divided by ending total assets), SRA is the standard deviation of ROA, PM is profit margin (calculated as net income divided by total revenues), VR is revenue volatility (calculated as the standard deviation of total revenues scaled by book value of common equity), VRM is the standard deviation of total revenues scaled by market value of common equity, and GUAR = 1 if a guarantee of investee obligations is disclosed (= 0 otherwise).

Table 1 presents descriptive statistics for the variables appearing in the models.6 For all variables, the amounts based on the equity method are significantly different from those based on proportionate consolidation. Under the equity method, a firm reports its investment in a significant influence investee as a single line item in the balance sheet, thereby netting its share of the investee's assets against its share of liabilities. In contrast, under proportionate consolidation, the investor's share of each of the investee's financial statement elements is combined on a line-byline basis with that of the investor. Accordingly, total assets (TA) and leverage (LEV) are greater under proportionate consolidation due the suppression of asset and liability amounts under the equity method. The suppression of total assets also results in significantly higher ROA under the equity method. Under the equity method, the investor's income statement contains its proportionate share of the investee's net income (loss) as a single line item. Accordingly, the suppression of investee sales amounts under the equity method results in greater reported profit margin (PM). Finally, the standard deviation for LEVM (VRM) is much smaller than that for LEV (VR), indicating that the substitution of market value of equity for book value is effective in addressing the small denominator problem. Table 2 presents a correlation matrix including all model variables. The correlations between bond rating (RATING) and each of the independent variables have the expected signs and are significantly different from zero, except for the Pearson correlations with LEV and volatility of
Consistent with Kothavala (2003), the extreme one percentiles of independent variable observations are winsorized to mitigate their influence.
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Table 2 Correlations between bond ratings and equity method and proportionate consolidation amounts; Spearman (Pearson) correlations in upper (lower) triangle (N = 173) Rating Rating TAE TAP LEVE LEVP LEVME LEVMP ROAE ROAP SRAE SRAP PME PMP VRE VRP VRME VRMP GUAR 0.65 0.64 0.02 0.04 0.55 0.54 0.53 0.58 0.30 0.31 0.51 0.50 0.01 0.02 0.60 0.64 0.15 TAE 0.58 0.99 0.25 0.25 0.32 0.31 0.36 0.37 0.08 0.09 0.34 0.33 0.32 0.31 0.50 0.50 0.10 TAP 0.57 0.99 0.24 0.23 0.31 0.29 0.36 0.35 0.03 0.06 0.34 0.31 0.31 0.30 0.50 0.49 0.10 LEVE 0.28 0.14 0.14 0.99 0.25 0.25 0.14 0.14 0.10 0.14 0.13 0.13 0.84 0.84 0.06 0.07 0.09 LEVP 0.27 0.10 0.07 0.93 0.27 0.28 0.16 0.16 0.06 0.11 0.15 0.16 0.83 0.83 0.06 0.08 0.09 LEVME 0.66 0.33 0.33 0.64 0.55 0.97 0.48 0.51 0.02 0.06 0.44 0.44 0.11 0.10 0.61 0.67 0.14 LEVMP 0.67 0.33 0.32 0.63 0.58 0.99 0.51 0.53 0.06 0.03 0.47 0.48 0.11 0.11 0.57 0.65 0.16 ROAE 0.62 0.36 0.37 0.36 0.30 0.62 0.62 0.97 0.28 0.26 0.96 0.95 0.20 0.19 0.41 0.41 0.03 ROAP 0.63 0.35 0.34 0.37 0.34 0.61 0.62 0.99 0.31 0.28 0.95 0.95 0.21 0.20 0.42 0.44 0.05 SRAE 0.31 0.04 0.00 0.10 0.03 0.04 0.01 0.15 0.19 0.96 0.26 0.31 0.01 0.01 0.02 0.05 0.05 SRAP 0.34 0.11 0.08 0.08 0.00 0.02 0.01 0.17 0.20 0.97 0.24 0.27 0.01 0.01 0.01 0.01 0.04 PME 0.58 0.39 0.39 0.31 0.25 0.58 0.58 0.95 0.94 0.08 0.10 0.98 0.19 0.18 0.40 0.41 0.02 PMP 0.60 0.37 0.37 0.32 0.29 0.59 0.60 0.95 0.95 0.14 0.13 0.98 0.19 0.18 0.40 0.42 0.02 VRE 0.28 0.16 0.14 0.60 0.62 0.35 0.37 0.33 0.36 0.19 0.17 0.30 0.33 0.99 0.06 0.06 0.15 VRP 0.23 0.13 0.11 0.58 0.63 0.30 0.33 0.28 0.31 0.20 0.16 0.25 0.30 0.97 0.05 0.05 0.15 VRME 0.74 0.51 0.50 0.34 0.30 0.76 0.77 0.56 0.56 0.03 0.03 0.60 0.61 0.36 0.32 0.98 0.04 VRMP 0.73 0.47 0.45 0.32 0.31 0.75 0.78 0.55 0.56 0.09 0.07 0.59 0.65 0.37 0.35 0.98 0.13 GUAR 0.15 0.11 0.12 0.09 0.07 0.20 0.21 0.11 0.13 0.26 0.25 0.09 0.14 0.13 0.12 0.13 0.21

Correlation coefficients significantly different from zero at p-values less than 0.05 are in boldface type. All variables are as defined in Table 1.

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revenue (VR). Substituting the market value of equity for book value in the leverage and revenue volatility variables strengthens their relation with RATING. For the Pearson correlations, there is no significant relation between RATING and either LEV or VR. However, these correlations are strongly positive for LEVM and VRM (ranging between 0.54 and 0.64). While the Spearman correlations between RATING and both LEV and VR are significantly positive (ranging from 0.23 to 0.28), the correlations are much greater for LEVM and VRM (ranging from 0.66 to 0.74). The correlations between the independent variables are generally moderate. A notable exception is the correlation between ROA and PM, which ranges between 0.94 and 0.96. As the numerators for these measures (i.e., net income) are the same, this reflects the high correlation between sales and total assets for manufacturing firms. Despite this high degree of correlation, collinearity is not a serious concern. Specifically, the condition indices for the regression models are less than 8, well below the rule-of-thumb critical value of 30 (Belsley, Kuh, & Welsch, 1980). 3.2. Results from regression analysis The results from estimating models (1) and (2) via OLS regression are presented in the third and fourth columns of Table 3, respectively. As the model is estimated on a pooled basis, statistical significance is assessed using HuberWhite robust standard errors (Huber, 1967; White, 1980). The robust estimator relaxes the assumption of independence of the observations. Further, clustering observations by firm produces correct standard errors even if the observations are correlated and heteroscedastic (Rogers, 1993). One-sided hypothesis tests are performed for those coefficients expected to have directional relations. The results indicate that proportionately consolidated financial statements have greater relevance for explaining bond ratings, as the BBS test of relative information content rejects equality for explaining RATING with a p-value of 0.001. The proportionate consolidation model has an adjusted R-squared of 0.672, while the equity method model has an adjusted R-squared of 0.631. This result is contrary to Kothavala (2003), who finds that amounts based on equity
Table 3 Summary statistics from OLS regression of bond ratings on equity method and proportionate consolidation accounting amounts and ratios (robust t-statistics in parentheses; N = 173) Variable Predicted sign + + + ? + + + Models (1) and (2) (E) 1.90 ( 7.52) 0.14 (4.43) 17.35 ( 1.56) 20.26 (2.32) 0.61 ( 0.08) 0.47 ( 6.66) 0.631 (P) 1.76 ( 8.02) 0.13 (3.44) 50.71 (5.19) 26.71 (2.11) 20.43 (2.95) 0.41 (5.38) E b P 0.001 0.672 Models (1) and (2) (E) 1.36 ( 4.36) 0.75 (2.65) 1.64 ( 0.16) 23.10 (3.64) 4.37 ( 0.60) 0.97 (2.30) 1.18 (1.33) 0.661 (P) 1.23 ( 4.11) 0.43 (2.18) 30.29 ( 2.29) 30.67 (2.89) 15.28 (1.70) 1.24 (2.93) 0.91 (1.06) E b P 0.045 0.684

TA(E,P) LEV(E,P) LEVM(E,P) ROA(E,P) SRA(E,P) PM(E,P) VR(E,P) VRM(E,P) GUAR BBS p-value Adj R2

Coefficient estimates significantly different from zero at p-values less than 0.01 (), 0.05 (), or 0.10 (), based on HuberWhite robust standard errors, are in boldface type. One-sided hypothesis tests are performed for those coefficients expected to have directional relations. The BBS p-value is from the test of relative information content in Biddle et al. (1995). All variables are as defined in Table 1.

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method accounting (adjusted R-squared = 0.32) have significantly greater explanatory power than amounts based on proportionate consolidation (0.22). Other than the BBS test results, the most notable difference across the studies is the relative explanatory power of the models. For the proportionate consolidation (equity method) model, the adjusted R-squared is 205% (97%) higher in the current study. This increase in explanatory power could be due to differences in (a) U.S. and Canadian GAAP, (b) bond rating methodologies, and/or (c) sample composition. With respect to accounting methods, differences in GAAP are not a likely cause given the overall similarity between U.S. and Canadian accounting standards (Doupnik & Salter, 1993). In addition, Webster and Thornton (2004) find no evidence of significant differences in accrual quality over the period 19902002 between Canadian firms reporting under Canadian GAAP and U.S. firms reporting under U.S. GAAP. Further, Leuz, Nanda, and Wysocki (2003) document low earnings management scores in both the U.S. and Canada. With respect to the bond rating process, a review of the methodologies and criteria as described on the Standard and Poor's and Dominion Bond Rating Service web sites reveals no substantive differences. With respect to sample composition, the current sample consists exclusively of manufacturing firms. While Kothavala (2003) does not provide data regarding industry membership, her sample appears to be more heterogeneous as the primary sample selection criterion is the existence of detailed data for joint venture investments. Based on the above, sample composition is the most likely cause of the differing BBS test results.7 With respect to individual coefficients, the estimates for all variables have the predicted sign, except for VR. Of the estimates with the expected sign, the coefficients on TA, LEV, ROA, and SRA all are significantly different from zero, as in Kothavala (2003). Based on the sample mean values of asset turnover (ATO), the marginal effect of PM on RATING has the expected negative sign under both the equity method ( 17.35 0.906 0.61 = 16.33) and proportionate consolidation ( 50.71 0.935 + 20.43 = 26.98). The unexpected negative coefficient estimates for the VR terms are consistent with Kothavala (2003); however, her estimates for the VR terms are not significantly different from zero. The results from estimating models (1) and (2) are presented in the last two columns of Table 3. The coefficient estimates for VRM are statistically significant with the expected positive sign under both the equity method (0.97, t = 2.30) and proportionate consolidation (1.24, t = 2.93). This change in results is attributed to the substitution of market value of equity for book value of equity. With respect to guarantees, the coefficient estimate on GUAR for the equity method regression (1.18, t = 1.33) is positive and marginally significant at the 0.095 level. While the estimate for proportionate consolidation (0.91, t = 1.06) has the expected positive sign, it is not significant. This difference is attributed to the explicit recognition of investee liabilities under proportionate consolidation. While the inclusion of GUAR reduces the difference between adjusted R-squared for the equity method (0.661) versus proportionate consolidation (0.684) regressions, the BBS test of relative information content indicates that the difference continues to be significant (at the 0.045 level). Thus, the model modifications do not affect the inference that proportionately consolidated financial statements have greater relevance for explaining bond ratings. To assess the robustness of the results from models (1) and (2), several additional analyses are conducted (results not tabulated). First, yearly indicators are added to the model to control for
Another sample-related possibility is that a fundamental difference exists in the nature of investments investigated. In the present study, significant-influence equity investments encompass associates, joint ventures, partnerships, etc. whereas Kothavala (2003) focuses exclusively on joint ventures. If these investments are characteristically different, it may explain some of the differences in results.
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Table 4 Summary statistics from ordered logit regression of bond ratings on equity method and proportionate consolidation accounting amounts and ratios in models (1) and (2) (robust t-statistics in parentheses; N = 173) Variable Predicted sign + + ? + + Coefficient (z-statistic) (E) 1.15 (3.45) 0.61 (2.54) 7.99 ( 0.75) 16.04 (3.05) 1.58 (0.21) 0.69 (1.92) 0.62 (0.85) 355.9 0.215 (P) 1.10 (3.51) 0.31 (1.93) 40.21 (3.21) 20.67 (2.30) 22.91 (2.50) 1.02 (2.57) 0.42 (0.54) E b P 0.001 345.9 0.237

TA(E,P) LEVM(E,P) ROA(E,P) SRA(E,P) PM(E,P) VRM(E,P) GUAR LR test p-value Log likelihood Psuedo adj. R2

Coefficient estimates significantly different from zero at p-values less than 0.01 (), 0.05 (), or 0.10 (), based on HuberWhite robust standard errors, are in boldface type. One-sided hypothesis tests are performed for those coefficients expected to have directional relations. The LR test p-value is from the logit-based Vuong likelihood ratio test from Hillegeist et al. (2004). All variables are as defined in Table 1.

time effects. Second, net income is adjusted for non-recurring items by removing special items (Compustat item #17), adjusted for income taxes by multiplying by 1 minus the statutory tax rate of 0.35. Third, both LEV and VR are log transformed due to skewness. Fourth, the 2 firms (7 observations) with negative book value are included in the estimation. Finally, an alternative to winsorization as a means to handle influential observations is utilized. Specifically, those observations with studentized residuals having absolute values in excess of 3 are deleted from the sample (Belsley et al., 1980). In each of these estimations, proportionately consolidated financial statements have significantly greater relevance for explaining bond ratings, based on the BBS test of relative information content. The results from estimating models (1) and (2) via ordered logit are presented in Table 4. These results are consistent with the OLS results in Table 3, with one exception the coefficient estimate for GUAR in the equity method regression (0.62, t = 0.85) is no longer significantly greater than zero. Both the log likelihood and pseudo R-squared for the proportionate consolidation model ( 345.9 and 0.237, respectively) exceed that for the equity method model ( 355.9, 0.215). Most important, the likelihood ratio test utilized in Hillegeist, Keating, Cram, and Lundstedt (2004) rejects equality of information content in favor of proportionately consolidated financial statements at the 0.001 level. To assess the robustness of the ordered logit results, the battery of sensitivity tests described above is performed (results not tabulated). In each of these alternative specifications, proportionately consolidated financial statements continue to have significantly greater relevance for explaining bond ratings. 4. Summary and concluding remarks This study provides additional evidence regarding the association between bond ratings and financial statement amounts under proportionate consolidation versus the equity method. Utilizing a sample of Canadian firms, Kothavala (2003) surprisingly finds that equity method

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statements are more relevant for bond ratings than are proportionately consolidated statements. The present study examines the same issue, using a sample of U.S. manufacturing firms. In contrast to Kothavala (2003), the results indicate that proportionately consolidated financial statements have greater relevance than equity method statements for explaining bond ratings. This result is attributed to greater sample homogeneity. This result is not altered when guarantees of investee obligations are included in the model. These findings add to the ongoing debate regarding the usefulness of financial statements prepared under alternative methods of accounting for significant influence equity investments.

Appendix A The following example illustrates how footnote disclosures for a sample firm are used to proportionately consolidate, on a pro forma basis, a significant influence investee. See Bauman (2003) for a more complete discussion of issues associated with proportionate consolidation based on footnote data. At December 31, 2001, Coca Cola Bottling Co. Consolidated (Coke Bottling) reports one material equity method investment a 50% interest in Piedmont CocaCola Bottling Partnership (Piedmont). Financial data follow:
Coke Bottling ($ millions) Balance sheet (equity method) Investment in Piedmont Other assets Total liabilities Shareholders' equity Income statement (equity method) Revenues Expenses Net income Summarized financial statement information for Piedmont disclosed in footnotes of Coke Bottling Total assets Total liabilities Partners' equity Revenues Net income $ 60.2 1004.3 1047.4 17.1

1022.7 1013.2 9.5

$ 365.5 245.1 120.4 296.9 0.8

With respect to the balance sheet, pro forma proportionate consolidation involves removal of the investment account ($60.2) and substitution of the investor's share of investee assets and liabilities [(0.5)($365.5 245.1) = $60.2]. Although not applicable to this example, goodwill is recorded in cases where the balance in the investment account exceeds the proportionate share of the investee's net assets. With respect to the income statement, net income reported under proportionate consolidation is equal to that reported under the equity method. When sales of inventory are made between investor and investee, realization does not occur until the inventory is consumed in operations or resold to an unrelated party. Accordingly, the amount of revenues reported under pro forma proportionate consolidation should be adjusted for unrealized intercompany sales. Since the information necessary to make this adjustment is not disclosed, no adjustment is made.

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Amounts for Coke Bottling under proportionate consolidation are computed as follows:
Balance sheet (proportionate consolidation) Investment in Piedmont Other assets Total liabilities Shareholders' equity Income statement (proportionate consolidation) Revenues Net income 60.2 60.2 = 0.0 1004.3 + (0.5)(365.5) = 1187.1 1047.4 + (0.5)(245.1) = 1170.0 17.1

1022.7 + (0.5)(296.9) = 1171.2 9.5

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