Reading Consolidated Financial Statements - dummies

Reading Consolidated Financial Statements

Most major corporations comprise numerous companies bought along the way to create their empires. The financial statement reflects the financial results for all the entities it bought as well as the original assets of the company.

After a stock acquisition by the parent company, the subsidiary continues to maintain separate accounting records. But in reality, the parent company controls the subsidiary, so it no longer operates completely independently.

Because the parent company now fully controls the subsidiary, by accounting rules, the parent company must present its subsidiary’s and its own financial operations in a consolidated manner (even though the two companies may be separate legal entities). The parent company does so by publishing a consolidated financial statement, which combines the assets, liabilities, revenue, and expenses of the parent company as well as those of its affiliates (that is, its subsidiaries, associates, and joint ventures).

If you hold a minority interest in the subsidiary of a parent company, the consolidated financial statement won’t give you the information you need to make decisions about your holdings. A subsidiary with minority shareholders must report its financial results separately from its parent company’s in addition to having its report included in the consolidated financial statements.

When a company owns all the common stock of its subsidiaries, the company doesn’t really need to publish reports about its subsidiaries’ individual results for the general public to peruse. Shareholders don’t even need to know the results of these subsidiaries.

In preparing consolidated financial statements, the parent company must eliminate numerous transactions among the parent and its affiliates before presenting the consolidated financial statements to the public. For example, the parent company must eliminate transactions among the parent and its affiliates for accounts receivable and accounts payable to avoid counting revenue twice and giving the financial report reader the impression that the consolidated entity has more profits or owes more money than it actually does. Other key transactions that a parent company must eliminate when preparing consolidated financial statements are

  • Investments in the subsidiary: The parent company’s books show its investments in a subsidiary as an asset account. The subsidiary’s books show the stock that the parent company holds as shareholders’ equity. Rather than double-counting this type of transaction, the parent company eliminates it on the consolidated statements by writing off one transaction.
  • Interest revenue and expenses: Sometimes a parent company loans money to a subsidiary or a subsidiary loans money to a parent company; in these business transactions, one company may charge the other one interest on the loan. On the consolidated statements, any interest revenue or expenses that these loans generate must be eliminated.

  • Advances to subsidiary: If a parent company advances money to a subsidiary or a subsidiary advances money to its parent company, both entities carry the opposite side of this transaction on their books (that is, one entity gains money while the other one loses it, or vice versa). Again, companies avoid the double transaction on the consolidated statements by getting rid of one transaction.
  • Dividend revenue or expenses: If a subsidiary declares a dividend, the parent company receives some of these dividends as revenue from the subsidiary. Any time a parent company records revenue from its subsidiaries on its books, the parent company must eliminate any dividend expenses that the subsidiary recorded on its books.
  • Management fees: Sometimes a subsidiary pays its parent company a management fee for the administrative services it provides. These fees are recorded as revenue on the parent company’s books and as expenses on the subsidiary’s books.
  • Sales and purchases: Parent companies frequently buy products or materials from their subsidiaries, or their subsidiaries buy products or materials from them. In fact, most companies that buy other companies do so within the same industry as a means of getting control of a product line, a customer base, or some other aspect of that company’s operations.
    However, the consolidated income statements shouldn’t show these sales as revenue and shouldn’t show the purchases as expenses. Otherwise, the company would be double-counting the transaction. Accounting rules require that parent companies eliminate these types of transactions.

As you can see, these major transactions are all critical for determining whether a company made a profit or loss from its activities. Eliminating assets, liabilities, revenue, and expenses from public view makes determining a subsidiary’s financial results nearly impossible for shareholders or creditors. But if these transactions were included, the value of the parent company’s stock would be distorted, because these transactions would be counted twice. The shareholders of the parent company would not know the true value of the company’s assets and liabilities; the income statement would not reflect the company’s true revenues and expenses.

The Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) tried to address the problem that shareholders and creditors of a subsidiary face by requiring parent companies to provide segmental reporting (reporting about subsidiaries, business units, and divisions of the company), which you also find in the notes to the financial statements.