Consolidated statements: Information goldmines
The word ‘consolidated’ in financial statement titles signals that subsidiary company financials are added to parent company financials. Large economic entities such as General Electric consist of one parent and hundreds of subsidiaries. Investors want consolidated financial statements because they are interested in the wealth controlled by the parent company, much of which resides in controlled subsidiaries. By adding subsidiary financials to parent company financials, valuable information is disclosed.
Finding stories in hidden subsidiaries
Suppose Parent, Inc. (hereafter Parent) invests in the equity of another company, named Subsidiary, Inc. (hereafter Sub) to the point where Parent owns more than 50 percent of the common shares of Sub. Parent is then presumed to control all the activities and operations of Sub because Parent cannot be outvoted on any shareholder proposal.
From a journalist’s viewpoint, most interesting article ideas stem from entities not consolidating subsidiaries that they effectively control. Often a parent company owns just less than 50 percent of a potential subsidiary’s shares, making it unclear whether control exists or not. There is always a possibility that managers choose not to consolidate another company to hide performance results.
Years ago Enron failed to consolidate entities that it effectively controlled, contributing to its fraudulent financial statements. During the 2008 financial crisis several large banks made payments to other entities to help them avoid bankruptcy. These payments surprised investors because the large banks were not consolidating the other entities, implying that the large banks weren’t responsible for them. But the payments effectively meant that the banks should have consolidated the other entities as subsidiaries. Investors complained that they didn’t know that the companies receiving payments even existed. Periodically analysts question whether Molson Coors Brewing Company, which owns 42 percent of MillerCoors, should consolidate it. Likewise, the Lenovo Group owns 45 percent of Beijing Lenovo Parasaga Information Technology Company but doesn’t consolidate it. The FASB has issued guidance that is causing some entities to start consolidating subsidiaries.
The problem with non-consolidated statements
To illustrate the importance of consolidation, consider a parent company that is small, consisting of a few employees, some furniture and not much else. Such a parent could control large world-wide companies within which all operations are conducted. The financial statements of just the parent company would not be very helpful to investors because they would consist of a few small assets and a one-line item titled something like “Investments in other companies.” With few details about the world-wide companies that the parent company controls (just a one-line description and investment amount) investors would struggle to understand the performance of the parent company and value it. Consolidation accounting helps overcome this problem by adding subsidiary financial statements to parent financial statements.
The accounting basics
Suppose Parent owns 100 percent of the outstanding shares of Sub. To produce consolidated financial statements Sub’s balance sheet account balances are added to Parent’s balance sheet account balances. This consolidation process helps investors assess the total cash available to the combined entity. If they only had Parent company financial statements it might look like Parent lacked cash, when companies it controlled had plenty of cash that they could send to Parent. The consolidated income statement works similarly. Sub’s Sales Revenue is added Parent’s Sales Revenue to generate Consolidated Sales Revenue.
Reporter’s Takeaway
- Often when ownership is just less than 50 percent—say 40 percent or more—a parent could control another company yet not consolidate it. That tends to hide information about the performance of the subsidiary and its relation with the parent.
- When a parent purchases another company, the consolidated performance is of interest to many capital market participants.
- Many frauds, such as the Enron debacle, hinged on not consolidating entities that it effectively controlled. Recently large banks made payments to companies that they did not consolidate, raising questions about opaque accounting.
