In finance terms, consolidation refers to the incorporation of the financial statements of all subsidiaries into the financial statements of the parent company.
Consolidation of financial statements requires the parent company to integrate and combine all its financials to create a standard-form income statement, balance sheet, and cash flow statement, as part of a set of consolidated financial statements.
Consolidation of Group Financials
As per IFRS 10 Consolidated Financial Statements, consolidated financial statements are where the company presents all assets, liabilities, equity, revenues, expenses, and cash flows of the parent company and all its subsidiaries as if the group was a single entity.
Consolidation also refers to the process of smaller companies combining into larger ones through mergers and acquisitions (M&A).
Consolidation accounting aims to present the information from the parent company and its subsidiaries as if it originates from a single entity.
There are different local requirements for presenting consolidated financials, but generally, the parent company needs to have control over the subsidiary. Usually, we consider 50% or more ownership to be equal to having control, but in some cases, we might regard holdings of less than 50% as controlling. To illustrate such a case, consider a small company that produces a specific part that is exclusively sold to our entity. Even though our business has no shareholding in the smaller company, we may have to consider consolidating it. Being the sole customer, we can dictate terms, and this means we effectively have control.
Whenever no control is present, or the parent company is presenting its separate financial statements, they can use the equity method (usually for holdings below 50%), or the cost method (often for holdings below 20%).
Financial Reporting Framework
Usually, the parent company and its subsidiaries use the same financial reporting framework when they prepare their separate and consolidated financial statements. If one or more subsidiaries report under different financial reporting standards, the parent company has to adjust the financials of these subsidiaries, as if they prepared them under the same financial reporting standards as the parent entity. We have to do this before consolidating the statements of the companies within the group to ensure proper reporting.
Let us take a look at the fundamental principles that underline the consolidation process.
Date of Acquisition
Most acquisitions happen at some point during the financial year, and not at year-end. This means we need to calculate the fair value of the net assets of the subsidiary at the acquisition date and consolidate as at this date. At the end of the year, we only consider the Income Statement of the subsidiary for the period after the acquisition date. The profit presented in the Balance Sheet at the time of acquisition is known as Capital Profit (pre-acquisition profit). The result for the period after the acquisition date (post-acquisition profit) is known as Revenue Profit, which we include in the Consolidated Income Statement.
Elimination of Intercompany Balances and Transactions
It is common for entities within the same group to do business with each other. Therefore we have two types of eliminations. We cancel out balances between related parties in the Balance Sheet as a receivable for Company A will be payable for Company B. The same happens to revenues and expenses in the period –we eliminated the amounts so that we do not inflate the Income Statement.
A parent company presents its investments in equity shares in its asset side of the Balance Sheet under Investments. The same is visible on the Equity side of the Balance Sheet of the subsidiary under Share Capital. If we acquired the investment at par, the two amounts are equal, and for the consolidation, we eliminate these in the Balance Sheet.
In reality, the acquired subsidiary may have accumulated profit or loss at the acquisition date, and the holding company usually acquires the shares either at a premium or at a discount. Whenever the purchase cost of an investment exceeds its par value, we recognize an intangible asset called Goodwill. On the other side, if we acquire the shares at a discount, we realize a Capital Reserve.
We can calculate Goodwill (or the Capital Reserve) with the following formula:
Non-Controlling Interest (NCI)
If we partly own a subsidiary, the rest of the shares that are held by other parties forms the Non-Controlling Interest. Also known as Minority Interest, it represents the proportion of net assets of the subsidiary that relates to outside investors. In the Consolidated Balance Sheet statement, we present the NCI as a separate line item within Equity.
We calculate the Non-Controlling Interest with the following formula:
Practical Consolidation Example
We will take a look at a simplified consolidation of the Income Statement and Balance Sheet of a company with three subsidiaries. Two of them are 100% owned by the parent company, and minority interest holds 20% of the third entity.
Keep in mind that this is an over-simplified example to illustrate the fundamental principles of financial statement consolidation.
First, let’s look at the Income Statements of the four companies. We ensure that these are presented following the same financial reporting framework and place them side by side.
The next step is to eliminate intercompany transactions, as discussed above. We know that our other subsidiary (MetricMaker) provides assembly services to Magnimetrics, the parent entity, which is the sole client of the subsidiary. Therefore the revenue recognized by the subsidiary is also booked as Cost of Sales in the parent company. We know we have to eliminate those, so the Income Statement is not inflated. In doing so, we remain with the Cost of Sales of MetricMaker, the subsidiary, and the Sales Revenue of Magnimetrics, the parent company. And this is how the whole transaction would look like if both companies were a single entity.
Next, let’s take a look at the Balance Sheet statements of the four companies.
We notice that the same subsidiary, MetricMaker, has € 461 thousand receivables from related parties. On the opposite side, the parent entity, Magnimetrics, has Intercompany payables at the amount of € 461 thousand. Following the same principle, we cancel these out.
Similarly, FunMetrics, our first subsidiary, has an outstanding balance of € 250 thousand owed to related parties. The parent company is the only one with remaining Intercompany receivables, and we can conclude that FunMetrics owes the amount to the holding company. The balance is probably outstanding from prior periods, as we had no transactions between the two entities in the year. Otherwise, we would have eliminated them in the Income Statement.
Canceling these € 250 thousand out, we have an Intercompany receivables balance of € 26 thousand, probably related to another associated party, which is not part of the consolidation.
We also have € 90 thousand Investments in the parent company. We need to eliminate 100% of FunMetrics and MetricMaker’s share capital against this investment. We also eliminate 80% of the share capital of Data Science 345, where we only hold 80% of the shares.
The other € 10 thousand of the share capital are part of our Non-Controlling Interest adjustment.
And here’s the working for our NCI, following the formula we discussed above in the prior year, and then adding the 20% attributable share from the result for the current year.
A parent company and its subsidiaries form one economic entity. Therefore investors, regulators, customers, vendors, and other stakeholders often prefer to look at consolidated financial statements when they evaluate the overall performance and position of the parent entity and its subsidiaries.
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The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained in the result of using the information presented in the publication.