Consolidating financial statements for parent and subsidiary companies or related companies can provide investors and other interested parties with a comprehensive overview of the financial operations of the entities. However, some detail gets lost during the consolidation process that can result in misleading presentation. Most public companies are required to report on a consolidated basis, but unconsolidated and segmented information must also be reported to ensure readers of the financial statements have all the relevant information.
What Are Consolidated Financial Statements?
Consolidated financial statements combine the balance sheets, income statements and cash flow statements of two or more companies or business units. They are often presented for companies that have one or more subsidiaries to show an overview of the entire operation. During the consolidation process under generally accepted accounting principles, activity between the companies disappears. A parent's investment in its subsidiary would be removed along with the matching equity on the subsidiary's books. Any inter-company sales would be erased as would the related cost of goods sold on the subsidiary's income statement. Consolidated financial statements can give readers a misguided sense of profitability and financial stability in the absence of non-consolidated information.
Masks Poor Performance
When income statements are brought together and reported on a consolidated basis, the revenues, expenses and net profit are presented as combined figures. This can hide any profitability issues with one or more of the companies. For example, if a subsidiary lost a substantial amount of money in the year as a result of poor sales, financial statement readers may not see that information if the loss is combined with profits of the parent company.
Skews Financial Ratios
One way that investors assess the viability of a company is by its ratios. Ratios are comparisons between financial statement lines. For example, the current ratio is current assets divided by current liabilities. This ratio tells investors how well the company will be able to pay its near-term obligations. In a consolidated financial statement, each company's assets, liabilities and income are combined. Financial ratios based on combined numbers may not be representative of each company's ratios. If one of the companies has a high level of debt compared to the equity of the owners, that leverage would be hidden in a consolidated statement.
Hides Inter-company Sales
All inter-company transactions are removed in a consolidation. On one hand, this presents a truer view of the companies by showing only financial activity with non-related parties. However, it also hides the level of inter-company transactions. If related companies spend most of their time and resources selling products or services in the group, an outside investor will not be able to assess transfer prices or profit-shifting in the group. Both of these things can be manipulated by companies and can affect income taxes. Consolidation hides the extent of the inter-company activity.