Combined vs. Consolidated Financial Statement Calculation

If you or your company are successful enough to own or invest in multiple businesses, that makes your corporate accounting a lot more complicated. You may have to combine or consolidate the business group's financial statements together rather than present a set of individual statements. American generally accepted accounting principles (GAAP) impose special rules for consolidated and combined statements.

Tip

If your company owns one or more subsidiaries, you merge their financial data and yours to create consolidated financial statements, treating the group like one corporation. Companies linked together, but not in a parent/subsidiary relationship, draw up separate financial statements, then combine them together.

Once companies become affiliates of each other, such as parents and subsidiaries, they often do business together. It may be more cost-effective to order supplies as a group, or for the parent to buy raw materials from a subsidiary.

Unethical companies have, in the past, gamed these transactions to cook their books or hide debts by shifting them to subsidiaries. Requiring the group to consolidate or combine their statements makes it harder for the group to conceal problems.

The two approaches under the GAAP rules are combining and consolidating the group's financial statements. For combined financial statements in GAAP, you draw up each company's financial statements separately, then combine them into one report. For consolidated statements, you make one set of financial statements that treat the entire group almost as if it were a single entity.

The choice of combined vs. consolidated financial statements depends on how the corporate group is structured. If it's one parent company with a controlling interest in one or several subsidiaries, then you're supposed to consolidate your balance sheet, income statement and cash-flow statement. If you're affiliated but there's no clear parent company, you combine instead.

For example, someone who owns a construction company might set up a second company to own the construction equipment, then lease it to the first company. Even though one person owns both, neither corporation has a controlling interest in the other. Combined statements are the way to go.

Suppose that you own Company A and decide it makes smart business sense to invest in Company B. You buy up 50% of the shares in Company B, and Company A buys another 30%. Company A doesn't have the power to control what Company B does, but your total investment means you do.

If you'd bought 80% of the shares through Company A, B would be a subsidiary. Consolidated statements would be the usual choice. As there's no parent company, the two corporations are only linked by your management.

The right approach is probably to combine A and B's statements rather than consolidate. This is not an absolute rule, however: If combining financial statements doesn't give investors and lenders clearer financial information, there's no point to it. It's a case-by-case decision.

If Company A owns the majority of the stock in Company B, consolidated statements are usually required. Majority ownership makes Company B a subsidiary of A, controlled by A's decisions. This also applies if A owns Company C, D, E or even more in the same parent/subsidiary relationship.

Even if Company A owns less than 51% of the voting stock, it may still be able to exert control over B. This can be done by contract, lease, court decree or an agreement with the other stockholders. In those cases, Company A still has to issue consolidated statements.

One good reason to be certain consolidated financial statements are necessary before you make them out is that these statements take work. For example, if you buy $3 million worth of silicon chips from a separate company, both businesses report the results in their ledgers and their income statements. If you buy from a subsidiary, you have to exclude such transactions from the consolidated statements because you're just buying from yourself.

Before starting to make out the consolidated statements, it's important to pin down which company is the parent. Everything in the consolidated statements is shaped to the parent company's point in view. In many cases, this is simple, but in some groups, the legal and financial ownership structures become tangled and harder to figure out.

Once you're clear who's who, there are multiple steps to keep in mind.

• If you consolidate the group's cash balances into one account, you have to record the transfers as inter-company loans. You allocate interest income on the account back to the subsidiaries.
  
  
• If you allocate corporate overhead to subsidiaries, you have to break down the amounts and assign it to Company B, C and so on.
  
  
• Some parent companies find it more efficient to consolidate their payables and payroll systems. These expenses have to be allocated to the right companies.
  
  
• Any inter-company revenue and expense transactions need to be adjusted. This includes not only parent/subsidiary transactions but transactions between subsidiaries.
  
  
• You have to verify the accuracy of your subsidiary accounts. This includes reading their individual financial statements and investigating any errors.
  
  
• If the subsidiary uses a different currency such as euros or Canadian dollars, you need to convert their financial statements into Company A's currency. 
  
  
• You report the group's income, expenses, gains and losses consolidated from all the different companies. If there's a minority ownership interest in a subsidiary, you have to allocate the consolidated amounts between your company and the non-control interest.  
  
  
• Even if the subsidiary runs on a different fiscal year, you still have to consolidate its financial statements with the parent.
  
  
• If a foreign subsidiary uses non-GAAP accounting, you have to make any changes necessary so that the consolidated statements conform to GAAP. 
  
  
• If a subsidiary simply uses different accounting that's GAAP compliant, there's no need to adjust during consolidation. For example, if you account for inventory using "first in, first out" methods and the subsidiary uses "last in, first out," you don't have to reconcile them. 
  
  
• If a subsidy isn't publicly traded, you exclude it from the consolidated statements. 

Combined financial statements in GAAP don't require as much work as consolidated statements. You compile statements for each individual entity in the group, then subtract out any purchases or transfers between group members. That places considerably less of a demand on your accounting department.

Combining statements allows investors to judge the value of each subsidiary and the value of the group as a whole. This approach isn't adequate to accurately capture the finances of a parent/subsidiary relationship though. But using a consolidation approach on what should be combined statements also distorts the reality of the financial relationship.

Suppose your company has $15 million in assets, including $5 million in cash, and $3 million in liabilities, leaving you with equity of $12 million. You spend $4 million to buy up all the stock in a small company, making it your subsidiary. You reduce your cash account by $4 million and record the $4 million in shares that you just acquired.

Although you put $4 million into Company B, when you make out your consolidated statements, your group's assets are still $15 million and equity is still $12 million. Not including Company B's equity would make your company look less valuable than it is.

Variable interest entities (VIEs) may require consolidated financial statements even if the parent company doesn't have majority ownership. A VIE is usually a company that lacks the equity to finance itself without financial support from the parent company. VIE characteristics may also include the inability to make decisions on its own.

The parent company has controlling interest in a VIE if the parent controls activities that shape the VIE's bottom line; has the obligation to absorb the VIE's losses; and has the right to receive significant benefits from the VIE.

You can use a series of tests to evaluate whether your relationship with another company meets VIE standards. For instance:

• Does control lie with a legal entity such as a corporation?
  
  
• Is the controlling organization subject to VIE standards? Employee benefit plans, governments and not-for-profits are not covered by the VIE model.
  
  
• Is your company the primary beneficiary of your control of the VIE?

If you don't pass the VIE test, then consolidation may still be required based on some other standard, such as ownership of voting stock.

One of the differences between consolidated and combined financial statements is the presentation of minority interest in consolidated financial statements. The minority interest, AKA non-controlling interest, is that portion of Company B that Company A doesn't own or control.

For example, suppose B has equity worth $10 million, but issued a $1 million financial instrument which pays off in equity. In combined financial statements, you'd still list B as having an equity of $10 million. The presentation of minority interest in consolidated financial statements requires you break ownership down to show the $1 million in minority interest separately.

If the instrument is listed on B's books as a liability rather than equity, you don't count it as a non-controlling interest. The GAAP rules for defining a non-controlling interest in this context can get complex.

Even if you consolidate your group's financial statements, there are times you want separate statements as well. If Company A owns B through F and decided to sell or spin-off C and D, investors will want financial information to judge those parts of the group, separate from the consolidated statements. Carve-out statements provide that information, and may also meet Securities and Exchange Commission (SEC) requirements.

A carve-out entity could be a portion of your company, or a group of businesses held by different subsidiaries that you control. The carve-out statements show the entity's historical operations and the operating costs. Exactly which historical periods you cover may depend on what information the buyer needs.

In some situations, you may not have enough information to create a carve-out statement. If, say, you're spinning off one product line into its own company, you may never have drawn up an income statement or balance sheet for the product line. In that case, the SEC may settle for an abbreviated statement giving revenues, expenses, assets acquired and liabilities assumed.

Sometimes bondholders, preferred shareholders and creditors want to know more about the parent company's finances than the consolidated financial statements provide. It's perfectly legal to provide interested parties with financial statements that focus on the parent company alone, but they have to be an extra. Substituting parental statements for the consolidated statements isn't acceptable.

Parent company statements do include your investments in subsidiaries, and in companies that you don't control. The statements must make it clear they are not your group's primary financial statements and should be read in conjunction with the consolidated statements.