Consolidated financial statements are documents prepared by a parent company that has invested in over half of its subsidiary companies’ common stock. These statements essentially integrate the parent’s statements with those of its subsidiaries.
Strictly speaking, the Financial Accounting Standards Board defines consolidated financial statement reporting as the reporting of an entity between a parent company and its subsidiaries.
Every time an investor acquires under 20% outstanding common stock of another company, the document presents the investment by applying the fair value or cost method. For all ownership interest between 20% to 50%, the equity method will be used.
Factors Affecting Consolidation Procedures
There are key points to be considered when deciding which accounting procedure is best used when consolidating financial statements. These include:
- Ownership (wholly-owned or subsidiary)
- Purchase consideration paid (for example, amount invested in subsidiary versus acquired stock)
- Group structure (number of subsidiaries, the existence of sub-subsidiaries, etc.)
When Is Consolidation of Financial Statements Required?
The consolidation of financial statements becomes necessary once the investor has acquired 50% of the subsidiary company. This is because owning half of another company gives the investor control over the investee’s business and financing decisions.
Now called a subsidiary, the investee is also considered an extension of the parent company at this junction. As per the key accounting principle that puts greater value on substance above form, the parent and subsidiary companies are now taken as one entity.
Steps to Consolidating Financial Statements
The process of consolidating financial statements differs on account of two main scenarios – when the acquisition is 100% and otherwise. This difference dictates which set of procedures are necessary to achieve the desired results.
Whole Acquisitions
The consolidation process for a 100% subsidiary acquisition is basic. It starts with determining a few essential facts, including the following:
- Date of acquisition
- Fair value of the purchase, and whether in cash or stock
- Contingent consideration, if any
- Acquisition date fair value of a subsidiary’s net assets
If the fair value of net identifiable assets is lower than the purchase consideration, this indicates goodwill from the acquisition. Otherwise, the acquisition is considered a bargain purchase.
The subsidiary’s assets and liabilities should also be compared with those of the parent’s at fair value. This is to know further depreciation and amortization related to the discrepancy between the subsidiary assets and liabilities’ acquisition date fair value and historical cost carrying value.
If there are any unrealized gains or losses within the group on inventory and fixed assets transactions, or any intra-group balances, these should be removed from the picture. The same should be done to equity balances of the subsidiary’s shareholders, as shown in their financial statements, where the investment in subsidiary balance is reflected on the individual financial statements of the parent company.
At this point, the revenues and expenses of the parent may be integrated with the subsidiary’s revenues and expenses after the acquisition, forming the consolidated net income as well as the consolidated retained earnings.
Consolidations Below 100%
If the parent doesn’t hold all of the subsidiary’s outstanding common stock, that means there are other investors in the company. These outstanding investors have what is called non-controlling or minority interest. When there is non-controlling interest, the consolidation process becomes a little more complicated than what is required in a hundred percent acquisition, as discussed above.
First off, the fair value of purchase consideration will be added to the fair value of the non-controlling interest, and the sum is then compared with the net identifiable assets’ fair value.
If there is an excess, it is taken as goodwill and will go to the parent and the non-controlling interest. The consolidated net income will also be allocated between the parent and the non-controlling interest according to their interest.
The consolidated balance sheet carries the amount of non-controlling interest, such as the shareholder’s equity that can be related to outside investors.
Finally, the consolidated retained earnings are computed using a unique process that excludes the subsidiary’s retained earnings that could be related to minority interest. In any case, a consolidation worksheet comes very much in handy as a tool in the consolidation process.
Limitations of Consolidated Statements
There is no question about the fact that consolidation statements are important to a parent company’s managers, directors, and stockholders. After all, the parent reaps benefits from the subsidiary’s income and other financial advantages. At the same time, however, it is affected by every negative movement taken by the same, such as losses.
As to creditors and minority stockholders of the subsidiary, these consolidated statements do not have much use. The subsidiary’s creditors only have an interest in the subsidiary itself and not the parent company. Minority stockholders of the subsidiary also do not gain nor suffer from anything that is related to the parent company.
While these minority stockholders have an interest in the subsidiary’s income and financial advantage, they are also negatively impacted by opposite developments within the subsidiary company. Therefore, the subsidiary’s creditors and minority stockholders have more interest in the individual financial statements of the subsidiary rather than in its consolidated statements.
Due to these issues, annual reports always come with the financial statements of the consolidated company, and in certain cases, those of the subsidiary companies alone, but never the parent company’s individual statements.
3 Major Limitations of Consolidated Financial Statements
1. Conceal poor performance
Consolidation means income statements will no longer report revenues, expenses, and net profit separately but rather combined. This can hide any profitability problems with one or any of the companies.
2. Skew financial ratios
Because they reflect a company’s viability, financial ratios are obviously crucial to investors. In consolidated financial statements, every company’s assets, liabilities, and income are reported as one, which means any derived ratios may be skewed and therefore do not accurately reflect each company’s individual ratio.
3. Masks inter-company income
Every inter-company transaction is eliminated when financial statements are consolidated. While this offers a more exact view of the companies, showing no more than financial activity with non-related parties, it does not accurately represent inter-company transactions.
Requirements for Financial Statement Reporting
There are few requirements for private companies when it comes to financial statement reporting, including consolidated financial statements. However, for public companies, all financial reports must follow the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP).
If a company is also reporting globally, it should also go by the guidelines of the International Accounting Standards Board’s International Financial Reporting Standards (IFRS). Both of these groups have each of their own standards for entities seeking to report consolidated financial statements with subsidiaries.
Wrapping Up
Consolidated financial statements are financial statements that collectively aggregate a parent company and its subsidiaries. The process for consolidating financial statements for full acquisitions is unique from that which is to be used for acquisitions below 100%.
While extremely beneficial to a parent company, these statements can also have their limitations, such as the way they hide poor performance and inter-company income, and skew financial ratios. Two bodies that regulate the creation of consolidated financial statements are the GAAP and the IFRS.
Should a company wish to skip consolidated subsidiary financial statement reporting, it can account for its subsidiary ownership with the use of the equity or the cost method.
FAQs
1. What are consolidated financial statements?
A consolidated financial statement is a financial statement that includes the assets, liabilities, and equity of two or more companies that are owned by each other.
2. What is the difference between consolidated and combined financial statements?
Combined financial statements are typically used for entities that are not owned by each other, whereas consolidated statements include entities that are owned by one another.
3. Who uses consolidated financial statements?
Public companies are required to use consolidated financial statements, while private companies may choose to use them if they wish. Any company that reports globally is also typically subject to global consolidation guidelines.
4. When are consolidated financial statements required?
Public companies are typically required to use consolidated financial statements in their annual reports. However, there may be other instances where a company is required to produce these statements.
5. How do you prepare a consolidated financial statement?
The process for preparing consolidated financial statements can be complex and depends on a number of factors. Generally, the individual financial statements of each subsidiary are combined into one master statement, and adjustments are made to account for any differences in ownership.
