CHAPTER FIVE

Consolidated Financial Statements

INTRODUCTION

Consolidated financial statements present the financial position and results of operations for a
parent (controlling entity) and one or more subsidiaries (controlled entities) as if the individual
entities actually were a single company or entity

Consolidation is required when a corporation owns a majority of another corporation’s

outstanding common stock.

The accounting principles applied in the preparation of the consolidated financial statements are
the same accounting principles applied in preparing separate-company financial statements

BENEFITES OF CONSOLIDATED FINANCIAL STATEMENT

Consolidated financial statements are presented primarily for the benefit of the shareholders,
creditors, and other resource providers of the parent. Significantly, consolidated financial
statements often represent the only means of obtaining a clear picture of the total resources of the
combined entity that are under the control of the parent company.

LIMITATIONS

While consolidated financial statements are useful, their limitations also must be kept in mind.
Some information is lost any time data sets are aggregated; this is particularly true when the
information involves an aggregation across companies that have substantially different operating
characteristics.

SUBSIDIARY FINANCIAL STATEMENT

Subsidiaries are legally separate from their parents, the creditors and stockholders of a
subsidiary generally have no claim on the parent, nor do the stockholders of the subsidiary share
in the profits of the parent. Therefore, consolidated financial statements usually are of little use
to those interested in obtaining information about the assets, capital, or income of individual
subsidiaries

The Tradition View of Control

The professional guidance regarding consolidated financial statements is provided in ARB 51

and FASB 94. Under current standards, consolidated financial statements must be prepared if
one corporation owns a majority of another corporation’s outstanding common stock.

OVERVIEW OF CONSOLIDATION PROCESS

The consolidation process adds together the financial statements of two or more legally separate
companies, creating a single set of financial statements. The specific procedures used to produce
consolidated financial statements are discussed in considerable details in Chapters 4 to 10.

The separate financial statements of the companies involved serve as the starting point each time
consolidated statements are prepared. These separate statements are added together, after some
adjustments and eliminations, to generate consolidated statements.

After all the consolidation procedures have been applied, the preparer should review the
resulting statements and ask: “Do these statements appear as if the consolidated companies were
actually a single company?”

Several items need to be given special attention to ensure that the consolidated financial
statements appear as if they are the statements of a single company:
• Interoperate stockholdings.
• Intercompany receivables and payables.
• Intercompany sales (i.e., unrealized profits)

Stated otherwise:
• “You can’t own yourself.”
• “You can’t owe yourself money.”
• “You can’t make money selling to yourself.”

Mechanics of the Consolidation Process

Where the simple adding of the amounts from the two companies leads to a consolidated figure
different from the amount that would appear if the two companies were actually one, the
combined amount must be adjusted to the desired figure.

No controlling Interest

For the parent to consolidate the subsidiary, only a controlling interest is needed—not 100%
interest. Those shareholders of the subsidiary other than the parent are referred to as “no
controlling” or “minority” shareholders. The claim of these shareholders on the income and net
assets of the subsidiary is referred to as the no controlling interest or the minority interest.

The FASB favors treating the no controlling interest as an ownership interest, with the no
controlling interest’s claim on subsidiary assets reported in consolidated stockholders’ equity and
the claim on subsidiary net income reported as an allocation of consolidated net income.

The no controlling shareholders’ claim on the net assets of the subsidiary is shown most
commonly between liabilities and stockholders’ equity in the consolidated balance sheet. Some
companies show the no controlling interest with liabilities although it clearly does not meet the
legal or accounting definition of a liability.

Different Approaches to Consolidation

 Several different theories exist that might serve as a basis for preparing consolidated financial
statements. The choice of consolidation theory can have a significant impact on the consolidated
financial statements in those cases where the parent company owns less than 100 percent of the
subsidiary’s common stock.

Different Approaches to Consolidation

• The remaining slides focus on the following alternative theories of consolidation:

• Proprietary
• Parent company
• Entity

Deferent theories

Proprietary Theory

The proprietary theory of accounting views the firm as an extension of its owners. The assets and
liabilities of the firm are considered to be assets and liabilities of the owners themselves.
Similarly, revenue of the firm is viewed as increasing the wealth of the owners, while expenses
decrease the wealth of the owners.

Proprietary Theory

When applied to the preparation of consolidated financial statements, the proprietary concept
results in a pro rata consolidation. The parent company consolidates only its proportionate share
of the assets and liabilities of the subsidiary

Parent Company Theory

The parent company theory is perhaps better suited to the modern corporation and the
preparation of consolidated financial statements than is the proprietary approach. The parent
company theory recognizes that although the parent does not have direct ownership of the assets
or direct responsibility for the liabilities of the subsidiary, it has the ability to exercise effective
control over all of the subsidiary’s assets and liabilities, not simply a proportionate share.

Under parent company theory, separate recognition is given in the consolidated balance sheet to
the no controlling interest’s claim on the net assets of the subsidiary and in the consolidated
income statement to the earnings assigned to the no controlling shareholders.

Entity Theory

As a general rule, the entity theory focuses on the firm as a separate economic entity, rather than
on the ownership rights of the shareholders of the parent or subsidiary. Emphasis under the
entity approach is on the consolidated entity itself, with the controlling and no controlling
shareholders viewed as two separate groups, each having equity in the consolidated entity.
Neither of the two groups is emphasized over the other or over the consolidated entity.

Because the parent and subsidiary together are viewed as a single entity (under the entity
approach), all the assets and liabilities of the subsidiary and any goodwill are reflected in the
consolidated balance sheet at their full values on the date of combination regardless of the actual
percentage of ownership acquired. Additionally, consolidated net income is a combined figure
that is allocated between the controlling and no controlling ownership groups

Definition of Pooling of Interest Method

The pooling of interest method is based on the assumption that the deal is nothing but an
exchange of equity securities. Hence the capital account of the firm acquired is removed and
replaced with the new stock by the acquiring company. The balance sheet of the two firms is
united, in which the assets and liabilities are shown at their book values, as on the date of
acquisition.

In the end, the aggregate assets of the united firm are equal to the aggregate of the assets of the
individual firm. Neither goodwill is general, nor there is a charge against the incomes.

The transferor company’s assets, liabilities, and reserves are entered in the books of accounts of
the transferee company, at their existing carrying amounts, after giving effect to relevant
adjustments.

Further, the reserves shown on the balance sheet of the transferor company is taken to the
transferee company’s balance sheet. The dissimilarity in the capital, as a result of exchange ratio,
is adjusted in the reserves.