Decision to Consolidate
The decision to consolidate financial statements when a company acquires a small company is based on the general rules listed below.
- The acquiring company will own the majority of the voting interest.
- The ownership of the voting interest exceeds 50%.
In either case, the company has to prepare financial statements on a consolidation basis. It implies that the decision to consolidate depends on the controlling financial interest in the company acquired. It means that the parent company will have an essential role in the financial decision-making process of the subsidiary. The parent company will have the right to variable returns from its investment in the acquired business. The decision to consolidate financial statements depends on the arrangement of the newly formed group and the transactions that take place between them. It is also noted that when the parent company and its subsidiary operate as a group, consolidated financial statements must be prepared and reported. However, it is possible that they operate entirely independently of each other. In this case, they can prepare their financial statements individually, but shareholders and other stakeholders prefer that companies report their financials on a consolidated basis. It removes ambiguities and possible overstating of accounts (Beams, Anthony, Bettinghaus, & Smith, 2017).
It is also essential to discuss FASB Interpretation no. 46(R), which requires companies to follow its guidelines for consolidating Variable Interest Entity (VIE). First, the VIE does not have sufficient equity investment at risk (FASB, 2008). Second, equity investors in the VIE lack any of three characteristics of controlling financial interest. Investors with such an interest participate in decision-making processes by voting their shares, expect to share in returns generated by the entity, and absorb any losses the entity may incur (FASB, 2008).
Consolidation Procedure
When a company owns more than 50% of another entity’s total equity, it should prepare and report its financial statements by using consolidation accounting. Companies must prepare their financial statements on a consolidated basis by using the same accounting methods according to the US GAAP, which was followed by the parent company and its subsidiaries before consolidation. The entire process of consolidation accounting is comprised of thirteen steps which are listed below.
- The parent company should record loans from subsidiaries and interest income earned on investments in them.
- The parent company should determine, allocate, and charge overhead costs to subsidiaries.
- It should perform verification of all payables charged to its subsidiaries.
- The parent company should determine, allocate, and charge payroll expenses to subsidiaries.
- It should post adjusting entries to all revenue and expense accounts.
- The parent company should verify the balances of each account of assets, liabilities, and equity.
- It should check and verify the financial statements of its subsidiaries to ensure that there are no mistakes.
- All intercompany transactions must be eliminated.
- The parent company’s financial statements should be checked and verified.
- It should record tax liabilities.
- It should close its subsidiaries’ accounts and books.
- The parent company should close its accounts and books.
- Finally, consolidated financial statements should be prepared and published.
The elimination of intercompany transactions is an important process that requires further explanation. This process requires that the equity accounts, including common stock and retained earnings of subsidiaries, must be eliminated on consolidation. The consolidated statement of income is prepared by only accounting for transactions that take place outside of the entity created. It implies that all transactions, including purchases and sales between the parent company and its subsidiaries, must be removed (Lessambo, 2018). In addition, certain transactions, including loans to and from subsidiaries, are also adjusted. These eliminations relate to accounts receivable and payable arising due to the transactions within the group. The investment of the parent company in the subsidiary is also adjusted and not included in the consolidated balance sheet. It implies that the consolidated balance sheet only reports combined assets and liabilities which are owed to external entities (Wahlen, Jones, & Pagach, 2017).
References
Beams, F. A., Anthony, J. H., Bettinghaus, B., & Smith, K. (2017). Advanced accounting (13th ed.). New York, NY: McGraw-Hill/Irwin.
FASB. (2008). FASB interpretation no. 46 (revised December 2003). Web.
Lessambo, F. I. (2018). Financial statements: Analysis and reporting. Cham, Switzerland: Springer.
Wahlen, J. M., Jones, J. P., & Pagach, D. (2017). Intermediate accounting: Reporting and analysis, 2017 update (2nd ed.). Boston, MA: Cengage Learning.