Economics Coca Cola Uses the Equity Method

Economics

Coca Cola uses the equity method of accounting and, inherent in that and similar to it the SABC (activity-based costing) method.

There are three cost accounting techniques:

The Cost method -- the company records all income as received and gains or losses are only realized when the item is actually sold or destructed. When a company owns 20% or less of another company, the Cost method is the preferred method.

Consolidation -- here financial statements of the parents and its subsidiaries are combined so that the net assets of both are reported together.

The Equity Method -- used when a company owns more than 20% but less than 50% of another company. The income from these products is recorded as a single line item on the financial statements. Coca-Cola owns less than 50% of its bottlers so it uses the Equity method. This method of accounting is usually applied when the company in question own more than 50% of another company.

The Equity method is related to ABC costing since only the indirect costs -- not those of labor, management, environment (Lockhart & Taylor, 2007) etc. are assigned to the products. This is beneficial for the company, as we will see, since it leverages its income on its income sheet.

The problem with Coke's accounting method -- and this is why there has been so much discussion centered on it -- is whether changes would be made to the Equity method of accounting which would force Coke to consolidate the financial statements of its bottlers with those of its own. Changes have been called for since even though Coke owns less than 50% of the bottling company, it dominates and imposes changes on them that makes these bottlers very much under their jurisdiction.

To understand why this may be problematic one has to understand the Equity method and the difference between the Equity method and Consolidation.

Companies who use the Equity method keep investments off their balance sheet, so if Coke owns 40% of its bottler and that bottler earns $1,000, Coke following the Equity Method adds $400 to its bottom line and to its balance sheet.

The Equity Method, using this strategy, benefit Coke's income statement since the income statement shows only the profits not the costs of the bottlers, hence only the high margin end not the low-margin business of the bottler is reflected on Coke's financial statements making it attractive to present and potential shareholders.

The balance sheet reflects a different reality. Coke's bottlers generally have a great deal of capital in both financing and debt and this appears on their balance sheet, but the syrup maker (of the actual coke beverage) doesn't have this so the entire debt load does not appear on its balance sheet, whilst the assets too don't impact their return of return on assets either.

Coke can legitimately decide to tread this route since it is using the Equity method which follows these principles and since it owns less than 50% of the bottling company.

However since it is so intricately connected with the bottling company, critics argue that Cokes' financial statements do not reflect a true reality and those they should use the Consolidation method rather than the Equity one.

In the Consolidation method, their return on equity would have been much lower falling, for instance, from 61% to 39% in 1996, whilst its return on capital too would have fallen from 37% to 25%. It also would not have been allowed to report as income its earnings that it made from the sale of equity investments in its bottlers. Obviously, the consolidated method would have been disadvantageous for Coke for it would have conspicuously lowered the amount on its income sheet particularly since, during some years; the equity sales reached high amounts of Coke's earnings. The Bank of China failed in its implementation of ABC costing due to various reasons not least lack of clear business purpose about the implementation and lack of clear education on the method (Abdallah & We lei, 2008). Coke seems to be knowledgeable about its advantages for them, although they still have to figure out how to deal with their critics. It may be that, in line with the example proffered by Krumwide et al. (2008), a combination of methods (perhaps ABC / Equity merged with some aspects of Consolidation) may meet their needs