Due to the impact of many objective factors (growth of business complexity, the need to diversify risks, the possibility of tax optimization, etc.), many entrepreneurs have a real need for the simultaneous development of many areas of activity, formation of many structural divisions and distribution of various business areas between several legal entities.
In addition, many corporations buy existing businesses or create new foreign companies in order to go global. Therefore, the overwhelming majority of large and medium-sized businesses are associations of several legal entities controlled by one individual owner or a group of individual owners.
To manage such businesses, company owners and other parties need consolidated financial statements. In simple words, these are accounting reports of a group of legal entities, drawn up as if they were one legal entity.
Drawing up consolidated reporting is one of the main and most difficult tasks of management accounting and analysis systems. Consolidated financial statements group the items of the financial documents of the parent company and its subsidiaries in such a way that they are presented as items of just one business organization.
Having in front of oneself a lot of reports from different companies, it is difficult for external users (shareholders, investors, government agencies) to determine the financial position of the group itself. That is why there is a need for consolidation. Its main purpose is to analyze and show the result of the economic activities of the entire group of companies.
Owners and managers also often need to see the details of the consolidated reporting. For example, they might look at more detailed data by having reports prepared based on the centers of financial responsibility, product type, region, and so on. Thus, consolidated financial documents in no way replace or make regular financial reports unnecessary or not valuable.
Instead, both complement each other and provide the management, owners, investors, and other users with more data to make effective and correct financial decisions. In fact, parent companies and subsidiaries are required to still present separate financial reports that cover only their own operations and the results of these operations.
There are many rules and standards that a parent corporation would need to adhere to when getting the consolidated financial statements ready. An important feature of companies being combined is the presence of a single control over the assets and operations of member companies and the ability to exert a decisive influence on the activities. Consolidated reporting is prepared if the parent corporation:
- owns more than 50% of the voting shares of a joint-stock company or more than 50% of the authorized capital of a limited liability company;
- has the ability to determine the decisions made by the subsidiary based on the agreement created before or in other ways.
The procedure for the consolidation of financial statements consists of three main processes: preparation of statements by each individual company in the group, making adjustments, and drawing up the consolidated statements themselves. It is essential to know that consolidation is not a simple summation of reports prepared by each entity that is part of the group. The choice of the consolidation method is determined by the level of control and influence the parent company has on the subsidiaries.
If a legal entity (subsidiary) included in the group uses an accounting policy that differs from what is used for consolidated documents or uses a different period for the preparation of statements, then when preparing the consolidated statements, the data on this legal entity should be adjusted accordingly.
It is possible to exclude a company from consolidated statements based on the materiality principle – if data is insignificant in comparison with the rest of the companies. At the same time, one of the most common methods of falsifying consolidated statements is to exclude companies specially created to withdraw profits or accumulate losses. With the scandalous bankruptcy of Enron in 2001, it turned out that it had falsified its statements for many years, creating offshore companies to transfer losses to them, and not including these companies in the consolidated reports.
Consolidated vs. Unconsolidated Reporting
As a general rule, unconsolidated financial statements are the provision of information about a parent organization, but not its subsidiaries. This information may be useful to existing and potential investors, lenders and other creditors of the parent organization. However, the information provided in these reports is generally insufficient to meet the information needs of the parent’s existing and potential investors, lenders and other creditors.
Therefore, when consolidated financial statements are required, unconsolidated financial statements cannot replace them. However, the parent may be required to prepare unconsolidated financial statements in addition to the consolidated ones. Another way to provide information about the parent organization itself is to present it in the notes to these consolidated reports.
Author: Charles Lutwidge