Before we discuss financial consolidation, it’s important to note the following definitions (IAS 27):
- A parent is an entity that controls one or more entities.
- A subsidiary is an entity that is controlled by another entity.
- A group is a parent and its subsidiaries.
- An associate is an entity that is controlled significantly by another entity (with more than 20%, but less than 50%, ownership)
So how does an entity control another?
Control exists when the parent company can direct the financial and operating activities of a subsidiary, and obtain benefits from these activities. That happens when a company has more than 50% voting right (more than 50% ownership) in the subsidiary, or when the parent company can direct the activities of the subsidiary through other contractual agreements.
What is financial consolidation, and what it is used for?
Financial consolidation is the process of joining the financial data of a company’s subsidiaries and segments (e.g., entities that company controls) into a single set of financial statements. Because the parent company controls its subsidiaries, it makes sense that the assets, liabilities, equity, income, expenses, and cash flows of the parent and its subsidiaries be presented in a financial statement as if they were a single economic entity.
Certain conditions render consolidation exempt, such as when the parent is a subsidiary of another entity, or when the parent's debt or equity instruments are not traded in a public market. The reasons for not consolidating certain financial aspects should be disclosed by notes in the consolidated financial statements.
Consolidated financial statements provide a company’s stakeholders a view into the company as a whole. Specifically:
- Regulators and auditing entities rely on this source to check whether a company is compliant with the rules and regulations it is bound to.
- Investors can rely on consolidated financial statements to assess a company’s situation, i.e., whether that company is winning or losing in its market place, and how that company’s operating, financing, and investing activities are being managed.
- High-level managers and executives review consolidated financial statements to evaluate their corporate performance and identify high- and low-value-added business segments as well as potential risks and opportunities.
Basically, financial consolidation is important for statutory and management reporting. Statutory reports serve external parties, such as regulators. Management reports, which serve the needs of a company’s managers, are more analytical in nature and normally not disclosed to third parties. Statutory reports might need to satisfy the requirements of many sources, including international accounting standards (IAS), IFRS, local GAAP, and government rules and legislations. Organisations operating in industries such as banking and insurance may need to adhere to additional reporting requirements.
Companies are responsible for giving a true and fair view into their consolidated financial reports. Failure to provide proper reports will result in the company being held liable for non-compliance fees and penalties.
For consolidation purposes, the financial statements of parent companies and its subsidiaries need to be prepared with the same date and uniform accounting policies. Though financial consolidation requires combining the financial statements of the parent and its subsidiaries, financial consolidation is not simply adding together the subsidiaries’ and the parent’s assets, liabilities, equity, incomes, or expenses. Instead, subsidiaries’ transactions are complex and usually require adjustments for consolidation.
Stay tuned for the next blog where we will take a closer look at how to account for a subsidiary’s minority interest in a group’s consolidated financial statements.