In order to get a broad view of a company's financial situation, you must look not only at the company's financials, but also the financials of its subsidiaries. Consolidated financial statements provide a way for investors to get this wholesale view for companies such as FedEx and Berkshire Hathaway.
In this article, we'll look at what sort of company must produce a consolidated financial statement, what information must be excluded from the statement and what special implications these statements present. (See also: Introduction to Fundamental Analysis.)
Who Uses Consolidated Financial Statements?
Companies are required to consolidate their financial statements whenever they own a controlling interest in another company. In other words, if a company is able to assert control of another company through its stake in it—regardless of the percentage of ownership—that company (called the parent company) must consolidate its financial statements with those of the subsidiary. (See also: What Are the Differences Between Affiliate, Associate and Subsidiary Companies?)
These consolidated statements provide a look at the operations of both the parent company and those of its subsidiaries; however, there is more to this than simply adding up the revenues of the parent and its subsidiaries.
Certain transactions—such as intercompany sales and dividends—must be eliminated from the financial statements in order to provide an accurate picture of how the company performed. These eliminations are essential to ensure that companies aren't artificially inflating their financial numbers.
Example: The importance of eliminations Let's assume Company A is the parent company of Company B. To make itself seem more attractive to investors, Company A could meet its sales goals by having Company B purchase a large chunk of its inventory. Company B then resells this inventory to consumers. This move would inflate the revenues of both companies and make it appear as if both companies sold more than they actually did. Eliminations prevent this sort of financial sleight of hand by removing intercompany sales from the financial numbers.
Some of the typical things eliminated from consolidated financial statements include intercompany sales, purchases, liabilities, assets and dividends attributable to affiliated companies. Also, the parent company's investments and shareholders' equity in subsidiaries are both partially eliminated. This ensures that the financial statements only reflect the independent operations of each company.
How Do Consolidated Financial Statements Come About?
Companies currently account for consolidations using one of two major accounting methods: the cost method and the equity method (either complete or partial). Regardless of the accounting method chosen, the end result is the same.
From the separate financial information of each company, the eliminations are made, usually through the use of what's called a "consolidated workpaper." Consolidated workpapers show the methodology used by accountants to step from individual statements to the consolidated statements. They provide a framework for eliminating accounting entries (which show up only on the books of the consolidated entity) in a manner that ensures no stone is left unturned.
Who Owns the Rest of the Subsidiary?
It's popular for companies to elect not to purchase a subsidiary in its entirety. One of the leading reasons for this is cost. Buying a 51% stake in a company is considerably cheaper than buying the whole thing, even though both claims provide the same amount of control in the subsidiary.
So, what about the other 49%? The remaining ownership in the company is still accounted for in the consolidated financial statements. It is referred to in these documents as "noncontrolling interest." Noncontrolling interest goes on the books as an equity account in much the same way that a sub-class of stock does. It makes sense to think of noncontrolling interest as a class of stock, such as preferred stock. For most intents and purposes, noncontrolling interest shareholders hold no sway in the way the subsidiary conducts its business. All of the control rests in the hands of the parent company. (See also: Knowing Your Rights as a Shareholder.)
Keep in mind that a parent can own less than 51% and still retain the controlling interest in a company. If no larger shareholder exists and the parent company has a significant amount of sway, it can be asserted that this shareholder has a controlling interest.
Using Separate and Consolidated Financial Statements Together
Think of consolidated financial statements as another tool to help you make an informed investment decision. While they do provide an overview of a company's operations, separate financial statements are still an important source of information.
Examining a company's finances along with those of its subsidiaries can offer a new perspective on a possible investment. For many companies, consolidated financials remain summary statements—that is, they are presented in a company's filings in a digest form, leaving out other information that can contribute to your overall view of the company's operations.
While not necessarily the solution for breaking down a company's financials, consolidated financial statements are a great way to make sure that you're getting the full view before you embark on any investment decision. (See also: What You Need To Know About Financial Statements and Advanced Financial Statement Analysis.)