Why do you think consolidation is needed? Why doesn’t the parent company just ac

Question

Why do you think consolidation is needed? Why doesn’t the parent company just acquire the assets and not the legal entity of its subsidiaries?

Why do we eliminate revenue, expenses, assets, liabilities, etc from the consolidated entity to the point that the sum of the separate legal entities is more than the consolidated entity?

What is the benefit of showing consolidated financial statements versus the equity method? How could a company manipulate financial presentation if it used the equity method instead of consolidation?  

Explanation / Answer

According to GAAP (Generally Accepted Accounting Principles), parent companies must prepare consolidated financial statements to report on the financial well-being of both the parent company and all its subsidiaries.

These statements are often prepared with the use of financial consolidation software which takes financial figures from each individual subsidiary and combines them into one overall report. Since each subsidiary also prepares its own standalone financial report, consolidated financial statements may seem to some to be an unnecessary extra step.

But is this really the case?

An analysis of the importance of consolidated financial statements reveals these statements offer several benefits to investors, financial analysts and others who may be evaluating the health of the parent company. In this article, we will review consolidated financial reports in more detail including the unique benefits they offer.

Benefits of Consolidated Financial Reports

Consolidated financial reports are a GAAP requirement for good reason. Some of the many benefits of consolidated financial reports include:

Complete Overview – Consolidated statements allow investors, financial analysts, business owners and other interested parties to get a complete overview of the parent company. At a glance, they can view the overall health of the business and how each subsidiary impacts the parent company.

Reducing Paperwork – With consolidated financial statements, there is also less paperwork involved. If the parent company owns nine subsidiaries, there are 40 separate standalone financial reports to view i.e. the four basic financial statements for each subsidiary plus the parent company. Not only would it be hard to track down all these records, it would be extremely difficult to look over each of them and try to get an overall view of how the business is performing. Consolidated financial statements cut this pile of reports down to just four consolidated reports. This results in less paperwork and less effort being expended to assess a parent company’s financial health.

Simplification – Consolidation software cuts out all transactions that occur between subsidiaries and the parent company since, in the grand scheme of the business, these things cancel each other out. Eliminating these transactions gives a simplified view of business performance.

Updates to Consolidated Financial Statements – Over time, consolidated financial statements will continue to evolve to make the process of evaluating a parent company even more transparent. One of the reasons for this is that in the past some companies have used consolidated reports to hide losses and liabilities in special subsidiaries that were created specifically for hiding these financial problems. The Financial Accounting Standards Board and the International Accounting Standards Board regularly revisit the definitions and requirements for consolidated statements in order to make them more reliable and easier to use.

The parent company just acquire assets not legal name of comapny because

A subsidiary corporation or company is one in which another, generally larger, corporation, known as the parent corporation,owns all or at least a majority of the shares. As the owner of the subsidiary, the parent corporation may control the activitiesof the subsidiary. This arrangement differs from a merger, in which a corporation purchases another company and dissolvesthe purchased company's organizational structure and identity.

Subsidiaries can be formed in different ways and for various reasons. A corporation can form a subsidiary either bypurchasing a controlling interest in an existing company or by creating the company itself. When a corporation acquires anexisting company, forming a subsidiary can be preferable to a merger because the parent corporation can acquire acontrolling interest with a smaller investment than a merger would require. In addition, the approval of the stockholders of theacquired firm is not required as it would be in the case of a merger.

When a company is purchased, the parent corporation may determine that the acquired company's name recognition in themarket merits making it a subsidiary rather than merging it with the parent. A subsidiary may also produce goods or servicesthat are completely different from those produced by the parent corporation. In that case it would not make sense to mergethe operations.Corporations that operate in more than one country often find it useful or necessary to create subsidiaries. Forexample, a multinational corporation may create a subsidiary in a country to obtain favorable tax treatment, or a country mayrequire multinational corporations to establish local subsidiaries in order to do business there.

Corporations also create subsidiaries for the specific purpose of limiting their liability in connection with a risky new business.The parent and subsidiary remain separate legal entities, and the obligations of one are separate from those of the other.Nevertheless, if a subsidiary becomes financially insecure, the parent corporation is often sued by creditors. In someinstances courts will hold the parent corporation liable, but generally the separation of corporate identities immunizes theparent corporation from financial responsibility for the subsidiary's liabilities.

One disadvantage of the parentsubsidiary relationship is the possibility of multiple taxation. Another is the duty of the parentcorporation to promote the subsidiary's corporate interests, to act in its best interest, and to maintain a separate corporateidentity. If the parent fails to meet these requirements, the courts will perceive the subsidiary as merey a business conduit forthe parent, and the two corporations will be viewed as one entity for liability purposes.

We eliminate these beacuse

Sale and purchase transactions incurred between the subsidiary companies, stock transfers made during the reporting period from one subsidiary company / unit and such stock being in unsold condition lying in the books of another subsidiary company / unit, involving unrealized profit element, intra group accounts receivables and accounts payables, etc. are certain types of transactions which are required to be removed from consolidated trial balance, worshiping the Business Entity Concept.

Certain events also give rise to some transactions which will be invalid as per Business Entity concept, such as mergers and one company being absorbed by another. It is highly essential in such case to clean up the consolidated accounts to comply with the applicable GAAP and also to honor the substance over form, where one can’t make profits from his own transactions.

The benefit of showing consolidated financial statement versus the equity method

Generally accepted accounting principles requires a company to use consolidated accounting when it owns a controlling stake in another business. In general, a controlling stake is one that involves ownership of more than 50 percent of a business. When a company owns a stake that is less than controlling but still allows it to exert significant influence over the business, it must use the equity method of accounting. Accounting rules generally define a controlling stake as between 20 percent and 50 percent of a company.

Main Differences

Consolidating the financial statements involves combining the firms' income statements and balance sheets together to form one statement. The equity method does not combine the accounts in the statement, but it accounts for the investment as an asset and accounts for income received from the subsidiary.

The manipulation of financial presentation by equity method is shown by a Case study

In its recent annual report, The Coca-Cola Company describes its 32 percent investment in Coca-Cola FEMSA, a Mexican bottling company with operations throughout much of Latin America. The Coca-Cola Company uses the equity method to account for several of its bottling company investments including Coca-Cola FEMSA. The Coca-Cola Company states that its consolidated net income includes the Company’s proportionate share of the net income or loss of these companies. The carrying values of our equity method investments are increased or decreased by our proportionate share of the net income or loss and other comprehensive income (loss) (“OCI”) of these companies. The carrying values of our equity method investments are also decreased by dividends we receive from the investees. Such information is hardly unusual in the business world; corporate investors frequently acquire ownership shares of both domestic and foreign businesses. These investments can range from the purchase of a few shares to the acquisition of 100 percent control. Although purchases of corporate equity securities (such as the one made by CocaCola) are not uncommon, they pose a considerable number of financial reporting issues because a close relationship has been established without the investor gaining actual control. These issues are currently addressed by the equity method. This chapter deals with accounting for stock investments that fall under the application of this method. 1 Learning Objectives After studying this chapter, you should be able to: LO1 Describe in general the various methods of accounting for an investment in equity shares of another company. LO2 Identify the sole criterion for applying the equity method of accounting and guidance in assessing whether the criterion is met. LO3 Prepare basic equity method journal entries for an investor and describe the financial reporting for equity method investments. LO4 Allocate the cost of an equity method investment and compute amortization expense to match revenues recognized from the investment to the excess of investor cost over investee book value. LO5 Record the sale of an equity investment and identify the accounting method to be applied to any remaining shares that are subsequently held. LO6 Describe the rationale and computations to defer unrealized gross profits on intra-entity transfers until the goods are either consumed or sold to outside parties. The financial statement reporting for a particular investment depends primarily on the degree of influence that the investor (stockholder) has over the investee, a factor typically indicated by the relative size of ownership.1 Because voting power typically accompanies ownership of equity shares, influence increases with the relative size of ownership. The resulting influence can be very little, a significant amount, or, in some cases, complete control.

Related Questions

Navigate

• Browse (All)
• Browse W
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.