Consolidated financial statements are a combined set of financial statements for companies with multiple divisions or subsidiaries. The term consolidated financial statement is used loosely; however, the formal definition under Generally Accepted Accounting Principles is combining the financial results of two entities into one set of information. This accounting requirement is in place for both domestic and international financial reporting standards.
Let’s say that your business is primarily in the manufacturing sector. You have decided to create a separate consulting business to supplement your manufacturing business. The manufacturing business owns 100% of the consulting business, making it the parent company. When it comes time to create consolidated financial statements, the manufacturing business will need to combine the financial information from the consulting business.
Creating consolidated financial statements is generally necessary once more than 50% ownership is held. For example, on the acquisition date of DEF Inc, ABC Inc acquired 80% ownership. From that point forward, 80% of DEF Inc’s ownership will be reported on ABC Inc’s financials. Due to the complexity of only reporting 80% ownership, many companies prefer to complete full acquisitions.
Consolidated financial statements are important for a variety of reasons. Let’s break down some of the benefits of issuing combined financial information.
When a company is obligated to issue consolidated statements, they generally have majority or full ownership of the subsidiary. This means that the transactions of the subsidiary have a direct tie to the financials of the reporting entity. For example, if the subsidiary sustains a large loss, the parent company will provide relief.
Neglecting to include the subsidiaries’ transactions on the financials of the parent company does not give the necessary transparency to investors or depict an accurate financial position. As a result, uniform accounting policies have strict requirements in place for companies with investment entities and subsidiaries.
Consolidating the financial statements of your company can also simplify reporting, especially for small subsidiaries. Issuing separate financial statements is costly and time intensive. On the contrary, adding a few transactions and notes to the financial statements of the reporting entity is relatively straightforward and simple.
When you can easily glance at your financial statements and understand the financial health of your entire organization, you can make more informed decisions. For example, using consolidated software that has financial information for your business and each consolidated subsidiary allows for better planning, forecasting, and growth projections.
Regulatory agencies want to know the companies your business owns, even if they are unrelated to your primary business activity. By issuing a consolidated statement, you are complying with the regulations set out by the Financial Accounting Standards Board and international accounting standards.
Consolidated financial statements contain the same components as individual financial statements. This includes the consolidated income statement, the consolidated balance sheet, and the consolidated statement of cash flows. Let’s quickly recap the information provided in each of these reports:
The financial data found in these reports will be shown as one single economic activity; however, many companies will also include supplementary information for each reporting entity. For example, they may include an income statement for the parent company and each subsidiary, helping investors understand the sources of transactions.
There are three primary ways that companies must report ownership in other entities: cost, equity, and consolidation. Cost accounting is commonly deployed if the company has under 20% ownership in the company. Between 20% and 50% ownership will warrant the equity method, while anything over 50% may be consolidated. Choosing the right accounting method is the first step in maintaining compliance with consolidated accounting requirements.
GAAP and International Financial Reporting Standards (IFRS) expand on these consolidation requirements. For one, parent companies and subsidiaries must use the same accounting method. Let’s say the subsidiary uses cash accounting for simplicity. If the parent follows accrual accounting, the financials of the subsidiary would need to be converted from cash to accrual.
One of the other main requirements for developing consolidated financial reports is the elimination of intercompany transactions. Many consolidated reporting entity operations are intertwined. Transactions paid from one company to the other need to be eliminated.
For example, let’s say that a manufacturer acquires a trucking company. Both companies operate independently, but the manufacturer owns 100% of the trucking company, which generates a consolidation requirement.
Like normal business operations, the manufacturer pays the trucking company to deliver goods. When it comes time to issue the financial statements, revenue from the manufacturer would need to be removed from the trucking company, while trucking expenses would need to be eliminated from the manufacturer’s books. Without these controls in place, companies could overstate revenue from intercompany transactions.
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