What are consolidated financial statements,
and how are consolidated financial statements prepared?
When reviewing an annual report, you come across the word “consolidated” everywhere!
When browsing the financial statements: Consolidated Statement of Income.
Consolidated Balance Sheet.
Consolidated Statement of Cash Flows.
When reviewing the key metrics: Consolidated Net Sales.
Consolidated Net Income.
When reading the supplemental schedules:
Consolidated Results of Operations.
Consolidated Subsidiaries.
Let’s start off with a definition of consolidated financial statements: the financial statements
of a group in which the assets, liabilities, equity, income, expenses and cash flows of
the parent and its subsidiaries are presented as those of a single economic entity.
Let’s illustrate that definition with some examples.
When you review the consolidated statements of income of Walmart Inc, you are looking
at the economic entity of the Walmart group, consisting of the parent company Walmart Inc
and a list of consolidated legal entities.
When you review the consolidated balance sheets of Apple Inc, you are looking at the economic
entity of the Apple group, consisting of the parent company Apple Inc and a list of consolidated
legal entities.
When you review the consolidated statements of cash flows of Tesla Inc, you are looking
at the economic entity of the Tesla group, consisting of the parent company Tesla Inc
and seven pages’ worth of consolidated legal entities.
The big question here is: to consolidate or not to consolidate?
Or more specifically: who to consolidate, and how to consolidate?
There is plenty of documentation on the subject of consolidation, that outlines the requirements
for the preparation and presentation of consolidated financial statements.
For US GAAP, ASC 810.
For IFRS, IFRS 10.
Let’s discuss the highlights.
Who to consolidate?
The core concept here is “control”.
Does the parent company have the power to direct activities of the subsidiary?
Does the parent have exposure, or rights, to variable returns of the subsidiary?
In other words, the obligation to absorb losses from, or right to receive benefits from, with
returns that must vary and can be positive, negative, or both.
Usually, there is control when ownership and voting rights exceed 50%.
However, in certain unusual circumstances, control may exist with less than 50 percent
ownership, when contractually supported.
This concept is referred to as effective control.
If control of a subsidiary is not established, then the investing company still needs to
account for the investment, through methods other than consolidation, for example using
the equity method of accounting, but that’s for a different video to discuss.
Let’s continue on the path of consolidation.
After determining who to consolidate, the next question is how to consolidate.
To a large extent, it is all one big summation.
To prepare consolidated financial statements, combine like items of assets, liabilities,
equity, income, expenses and cash flows of the parent with those of its subsidiaries.
In addition, there may be the need to eliminate intercompany transactions and intercompany
ownership or financing positions.
Here are two common examples.
There may be intercompany sales between entities within the group.
For example, if you look at the annual report of the Coca-Cola company, the line total net
operating revenues consists of third party (external) revenues,
as well as intersegment revenues.
In 2019, the Asia Pacific operating segment had $4.7 billion of third party revenues,
and $600 million of intersegment revenues.
Let’s T-account the journal entries of the intercompany sales transactions, using numbers
that are obviously not the actual real-life Coca-Cola numbers (as you can find information
about the company’s consolidated gross margin,
but obviously not about the internal transfer pricing).
The journal entries for recording intercompany sales in the selling entity are: debit intercompany
accounts receivable for 70, credit intercompany sales for 70, and debit cost of goods sold
for 40, credit inventory for 40.
The difference between the amount recorded in intercompany sales and the amount recorded
in COGS is the margin of 30 on the intercompany sales for the transferring entity.
The receiving entity first books debit inventory for 70,
credit intercompany accounts payable for 70.
For the receiving entity, the value of the inventory equals the cost of what it purchased
the inventory for, which is 70 in this example.
This is fine on the entity level, but remember that for the group no profit is recognized
until the sale to an outside party has been realized!
Once the receiving entity sells externally, it books debit accounts receivable for 100,
credit external sales for 100, and debit cost of goods sold for 70,
credit inventory for 70.
On the consolidated global level, those intersegment revenues and margins have to be taken out
to avoid double counting, this happens in the “eliminations” column.
What we want to keep to correctly report on the group level, are the items circled in
red: the external sales and the cost of goods sold based on the manufacturing cost.
What we primarily want to eliminate on the group level, are the intercompany sales, and
the cost of goods sold that are based on the intercompany transfer.
The transactions in the books of the individual operating segments are kept in place, while
in the “eliminations” ledger offsetting journal entries are booked to correctly state
the group level totals.
To eliminate intercompany sales, a journal entry is recorded debiting the intercompany
sales account by 70, crediting the cost of goods sold account by 70, and when applicable
(in case not all of the transferred inventory has been sold externally yet) crediting the
inventory account.
If any transferred inventory is unsold at the end of the reporting period, the credit
of the journal entry is split between COGS and inventory (60/10, 50/20, 40/30, or whatever
the actual ratio might be).
The debit to intercompany sales eliminates intercompany sales on the group level.
The credit to cost of goods sold eliminates the intercompany COGS and therefore the margin.
The credit to inventory eliminates the intercompany profit on goods still in inventory (in other
words not sold externally yet).
When intercompany inventory on the balance sheet at the end of the period is zero, then
the full credit leg of the journal entry goes to COGS.
In addition, the accounting team reviews the intercompany accounts receivable and accounts
payable balances at the end of the reporting period.
If there are any remaining “due to / due from” balances, then these are eliminated
by crediting accounts receivable and debiting accounts payable.
The second example of common intercompany elimination entries is intercompany ownership.
Let’s take the example of a parent company with three direct subsidiaries A, B, and C,
and a “grandchild” D, which is the subsidiary of C. The parent company holds a balance of
$10 billion in the account investment in subsidiaries (on the assets side of the balance sheet).
Subsidiary A has $5 billion in equity (held by the parent), B $3 billion, and C $2 billion.
The sum of the investment in subsidiaries for the parent is equal to the sum of the
equity balances in the subsidiaries.
In turn, subsidiary C has an investment in subsidiaries of $1 billion, mirrored by the
equity on the balance sheet of subsidiary D. Like in the previous example, the balances
in the books of the individual operating segments or legal entities are kept in place, while
in the “eliminations” ledger offsetting journal entries are booked to correctly state
the group level totals.
In the “eliminations” ledger, the account investment in subsidiaries is credited for
$11 billion, while the equity account is debited for $11 billion.
As a result, for the group, the sum of each of the accounts investment in subsidiaries,
and equity from parent, is zero.
Similar elimination journal entries would be recorded when there are intercompany loans
between parent and subsidiaries, or among subsidiaries.
So where do you find information about consolidation in an annual report?
Go to the notes to the consolidated financial statements, section “principles of consolidation”,
and you will find both the “who” and the “how” of consolidation.
For example, Walmart states that it consolidates variable interest entities where it has been
determined that the Company is the primary beneficiary of those entities' operations,
and that intercompany accounts and transactions have been eliminated in consolidation.
Consolidated financial statements.
The financial statements of a group in which the assets, liabilities, equity, income, expenses
and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity.
Who to consolidate?
The core concept here is “control”.
How to consolidate?
Combine like items of assets, liabilities, equity, income, expenses and cash flows of
the parent with those of its subsidiaries, and record applicable eliminations.
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