A Test of Pro Forma Consolidation of Finance Subsidiaries

In consolidating financial statements, traditional practice has excluded finance subsidiaries from the consolidated balance sheets of their parents. A persistent concern has been that the resultant omission of finance subsidiary debt from consolidated totals would cause the financial leverage of the parent to be misjudged. This proposition was tested by comparing the degree of association of (i) pro forma consolidated measures and (ii) parent-only measures of financial leverage with (iii) the parent's systematic risk (market beta). The findings reveal that systematic risk is more highly associated with pro forma-consolidated leverage measures than those based upon parent-only data. This evidence indicates that financial leverage is not being misjudged through non-consolidation, and that market participants are performing their own pro forma consolidation of finance subsidiary debt.