Consolidated and standalone financial statements this word are generally seen in annual reports. Both type of financial statements give information about same company for the same period.
Many times reader get confused which one to use.
Questions pop out in their mind such as:
- What is different between consolidated and financial statements?
- Which one is more relevant for investor?
- Why some companies has only standalone statements while others have both?
We will take a look at all such topics in this article.
Company have to publish both standalone and consolidated financial statements, when it has one or more subsidiaries associates or joint venture over which it has direct or indirect control and can exercise same when required.
Before getting into consolidated statements are prepared reader shall be familiar with certain terms:
A subsidiary is enterprise which is directly or indirectly controlled by other enterprise.
Direct and indirect control:
An enterprise is said to have control over other when:
The equity ownership directly or indirectly through other subsidiaries is more than 50%. In other words holds more than 50% shares in other company.
One enterprise have control on more than half of board of other enterprise. (one company can appoint or remove more than half of board of directors. It means that company will have voting power in operating decision of subsidiary controlled company.)
Holding company /Parent company :
Holding company and parent company are interchangeably used terms.
An enterprise is holding company for other enterprise when it has control over other enterprise.
Associate company :
An associate company is one which is not subsidiary company but parent company have significant interest and control over it.
Company is said to have significant interest when it hold more than 20% investment in shares.
Ownership interest in subsidiary which is not acquired by parent company directly or indirectly through any other subsidiaries.
Minority interest is always less than 50%. There is head for minority interest in consolidated balance sheet.
Joint Venture :
According to Investopedia.
A joint venture (JV) is a business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific task. This task can be a new project or any other business activity.
In a joint venture (JV), each of the participants is responsible for profits, losses, and costs associated with it. However, the venture is its own entity, separate from the participants’ other business interests.
Joint venture is good alternative for mergers and acquisition .
Basic Theories behind each type of financial statements
Standalone financial statements
According to standalone financial statements investments made by parent company in subsidiaries joint ventures or associate companies shall be treated just like normal investments in shares. Irrespective of control that company may gain from acquisition of large portion of equity.
And so such investments shall be recorded as Long term investments in balance sheet. Only income recognized in the form of dividends shall be considered in profit and loss statements.
Consolidated Financial Statements
On the other hand consolidated financial statements recognizes importance of control or influence gained because of investment in subsidiaries joint ventures(JV) and associate companies.
Parent company have full control over its operating decisions of subsidiaries and joint venture where share in capital is more than 50% and some control in case of associates. Thus instead of considering this investments just like other investments in share it shall be treated as part of business.
Because of this in consolidated financial statements the parent company’s financial statements and its subsidiaries must be combined line by line by totaling similar items like assets liabilities income and expenses.
Unlike standalone financial statements here dividend obtained from investments is not recognized as income. But profit from such businesses equal to the portion of investment in capital is considered as actual income.
While items in financial statements are added line by line but some adjustments are done in order to get more clear and correct information in consolidated financial statements.
Adjustments and procedure for preparation of Financial Statements
Cost of investment(price at which shares in subsidiaries, associates are acquired) which is in the balance sheet as investment shall be eliminated.
Capital portion attributable to parent company should be eliminated from books of subsidiary.
Remaining equity portion which is attributable to minority is shown in separate heads called as minority interest.
If cost of investment is greater than equity company is getting then different should be recorded as goodwill.
Sometimes opposite may be true then difference in such case shall be recorded as reserves and surplus in consolidated financial statements.
If there is selling of goods between parent and subsidiary and those goods are still in inventory then profit margin charged on inventory shall be eliminated by company holding goods. And equal amount of sales shall be reduced from seller.
This is because you cannot earn profit when you sell something to yourself.
Income recognized as dividends from subsidiaries joint ventures and associated shall be eliminated in full.
If there is transaction between parent and subsidiaries which results income to one and expense to other then such transactions shall be eliminated.
Cash flow statements
No adjustments needs to be done in case of cash flow statements just add items line by line to combine both statements .
Which statements shall be used for investment analysis ?
In the case of subsidiaries parent companies actually take most of the operating decisions and set competitive strategies. So the success of subsidiary should not be measured in divided income only but in the operating income that subsidiary will earn.
This control factor is completely considered irrelevant in standalone to have right to control has some value which is reflected in goodwill in consolidated statements (CFS).
Inter-group transactions can artificially inflate earnings of both the companies. Thus have more room for frauds but their effect are nullified in CFS.
Parent company may be earnings good return on capital. On the other hand subsidiaries may be burning tons of money in that case standalone financial statement will show zero income from dividend but that loss will remain hidden.
Because of such reasons it is always better to use consolidated financial statements rather than standalone financial statements.