Consolidated financial statements might seem very difficult and confusing to many of you reading it for the very first time. But the purpose of writing this guide is to make it as clear for you all as possible. Consolidated financial statements are the combined financial statements of a holding company and all of its subordinates.
The reason behind it is that consolidated financial statements present an overall financial view of a parent company and all of its controlled subservient companies. So the financial data obtained from these statements helps compare the status of the company’s position as compared to other leveling firms in the industry.
How Does It Work?
Let’s say there are three different companies: Company X, Company Y and Company Z. Company X is the parent company and company Y and Z are its subsidiaries. The holding company can operate as a sovereign cooperation keeping aside its subsidiaries. But the subsidiaries pay a large amount of fees to the holding company. So during financial year end, company X’s financial statement reflects the large number of fees given to it by the subsidiaries and very few expenses. So when a potential investor looks at the holding company’s financial statement, they could get a false view of company’s performance.
But if Company X consolidates its financial statement by adding cash flow sheets, income statements and balance sheets of the holding firm X and the subsidiaries company Y and Z, the results will give a clearer and fairer picture to the investor. Organizations need to exclude all the transactions happening between the firms. But they do this like all the transactions that take place between Company X, company Y and company Z in this example. Those transactions are moments of cash, assets, revenues or expenses between the firms. Their purpose is to avoid them from counting from both sides of firms.
Why It Matters
- You can obtain a comprehensive analysis of a company’s operations from consolidated financial statements. Without the provision of the statement a potential investor can never get an idea of how a firm as a whole is doing in business, whether it is progressing or making a loss.
- It should provide a fair and true picture of financial status and output result of a firm. Generally accepted accounting principles (GAAP) suggest when and how you should consolidate statements should. They also decide whether it is necessary for some organizations to produce consolidated financial statements or not.
- The policies and procedures for financial statements should apply again and again for the best outcome of results. Also, they shouldn’t be changed without any major cause.
- If the parent company holds only a minor share in a subsidiary, for example, Company X only has a share of just 5% in Company Z. So it would not consolidate the financial statement of Company Z with it.
- In cases where companies hold 100% share of the subsidiary, then consolidation is not necessary. But normally companies break up their consolidation by division. This way, investors can get a better idea of the performance of each entity.
All You Need to Know: 4 Key Aspects of Consolidated Financial Statements
1. Consolidated Statement of Income
It is very important to keep in mind that consolidated financial statements require transactions outside of the parent company and its subsidiaries. Any profit that the holding company earns and goes into its subordinates as their expense or any other cost and any profit of subsidiaries that goes to the parent company or any other subsidiary will be excluded from the financial statement.
To avoid abnormal profits, we will omit any transaction happening between the firms. The net change in financial statement is always $0. So we need to give investors a better image of the progress of the firm and keep it fair when comparing progress of its different economic entities. Therefore, all the external values cancel from the financial statement.
2. Requirements for Consolidated Financial Statements
You should use a similar accounting method should for making consolidated financial statements both for the holding company and the subsidiaries. Generally accepted accounting principle (GAAP) is the globally recognized accounting principle. So, the financial statements of the holding company and its subsidiaries must be according to that of GAAP.
You must eliminate subsidiary equity accounts before making the financial statement. Also, any transaction happening within the holding firm and the subsidiaries don’t fit there as well. Equity accounts such as retained earnings where the percentage of earnings are reinvested in the firms and common stock of equities must also be disposed of. You should remember that when preparing for consolidated financial statements. The value of financial assets of subsidiaries’ balance sheet passed revision and brought to the current value of market price.
3. Method of Calculating Ownership
Generally there are two methods that apply when calculating the ownership interest between firms. Ownership is totally dependent on the total amount of stock that the companies own. Percentage of stock ownership determines the value of the company. So only those companies are included in the financial statements that the holding firm owns.
- First one is the cost method of financial reporting. It applies when a company wants to know about the financial activities by making small investments in other business. In these businesses they own less than 20% of another’s company stock.
- The second method is equity method. A firm must use this method when it owns a very compelling but not the majority stake in another company. This is more than the minimum of 20% to 25%, but less than 50% to determine the ownership. But we must keep into perspective that under both of these methods consolidated financial statements are not permissible.
4. Consolidated Balance Sheet
Many payable balance accounts and receivable balance accounts that a parent company or its subsidiaries own eliminate from the consolidated balance sheet. The same happens with the statement of income. The purpose of eliminating these accounts is to reduce the balances reported on consolidated financial statement and the net effect is always $0.
Everything present on the financial statement like cash and assets are liable to external parties not to the parent company or subsidiaries.
The consolidated financial statements are tools you need to master, in order to keep your company safe financially. However, an accountant is also aware of these and takes the necessary actions.
Make sure that you read our guidelines. If you have any further questions, please share them in a comment below.