A subsidiary is a company that is controlled by its parent company. The subsidiary acts and operates as its own entity, but it is still connected to the larger company. The parent company can create a subsidiary in one of two ways: by creating it from within the parent company or by acquiring a controlling interest in an outside entity. When there is majority ownership or control, the investor corporation guides the resources, business policies, and operating decisions of the subsidiary.
Why Form a Subsidiary?
There are several advantages for the parent company in acquiring or forming a subsidiary. For example, a company may seek additional resources that another company can provide, a company might want to enter a new market that another company dominates, or a company with multiple brands may create subsidiary companies to keep its brand identities separate and increase brand recognition.
Financial considerations are another issue that may influence the creation of a subsidiary, such as when a company wants to sell off an unprofitable business center without disrupting the overall operation of the business. In this case, organizing it as a subsidiary and subsequently selling it off would achieve that goal. A company can also raise capital by selling off stock in the subsidiary without affecting the parent company's stock.
Subsidiaries and Combined Financial Statements
Subsidiaries also allow a company to keep certain business operations private and avoid disclosure under SEC requirements by keeping the subsidiary privately held. This is particularly advantageous when a company is developing a new product.
Financial statements are prepared in the same way for the subsidiary as they are for the parent company. However, in addition, consolidated balance sheets are prepared. This is the combined financial statements of the parent company and all of its subsidiaries. The consolidated financial statements give an overview of how well the entire corporation is being managed and are useful in valuing the company as a whole. The shares owned by outsiders are shown on the balance sheet as an item. The consolidated balance sheet also includes foreign subsidiaries. However, it is sometimes difficult to convert the financial statements of a foreign subsidiary back into the parent company's currency.
When a company is listed on the stock exchange, the information found on the financial statements is consolidated.
Consolidated financial statements are of paramount importance to stockholders, managers, and directors of the parent company. Any subsidiary benefits from the income and strengths of the parent company while the parent company suffers the detriment from any weaknesses or losses from the subsidiary.
However, the consolidated financial statements are of limited use to creditors or minor stockholders of the subsidiary. For example, a subsidiary’s creditors have a claim against the subsidiary alone, and they cannot expect payment from the parent company. Minority stockholders are not affected by the parent company’s operations, but they do benefit from the subsidiary’s strengths and weaknesses.
Therefore, because the subsidiary's stakeholders are more interested in the subsidiary’s individual financial statements than in the consolidated statements, company annual reports often include both the consolidated statements and the subsidiary statements, but never the parent's financial statements alone.
The decisions and quality of management of the parent company affect the subsidiary. Therefore, it is crucial to include the parent company information when analyzing a subsidiary.