Question

A parent company and its subsidiaries are separate legal entities. Hence, they have separate accounting records. Explain why they may be consolidated.

Answer 1

A parent company and its subsidiaries maintain their own accounting records and prepare their own financial statements. However, since a central management controls the parent and its subsidiaries and they are related to each other, the parent company usually must prepare one set of financial statements. These statements, called consolidated statements, consolidate the parent’s financial statement amounts with its subsidiaries’ and show the parent and its subsidiaries as a single enterprise.

According to FASB Statement No. 94, consolidated statements must be prepared (1) when one company owns more than 50 per cent of the outstanding voting common stock of another company, and (2) unless control is likely to be temporary or if it does not rest with the majority owner (e.g. the company is in legal reorganization or bankruptcy).Thus, almost all subsidiaries must be included in the consolidated financial statements under FASB Statement No. 94.

Consolidated financial statements are of primary importance to stockholders, managers, and directors of the parent company. The parent company benefits from the income and other financial strengths of the subsidiary. Likewise, the parent company suffers from a subsidiary’s losses and other financial weaknesses.

Consolidated financial statements are of limited use to the creditors and minority stockholders of the subsidiary. The subsidiary’s creditors have a claim against the subsidiary alone; they cannot look to the parent company for payment. Minority stockholders in the subsidiary do not benefit or suffer from the parent company’s operations. These minority stockholders benefit from the subsidiary’s income and financial strengths; they suffer from the subsidiary’s losses and financial weaknesses. Thus, the subsidiary’s creditors and minority stockholders are more interested in the subsidiary’s individual financial statements than in the consolidated statements. Because of these factors, annual reports always include the financial statements of the consolidated entity, and sometimes include the financial statements of certain subsidiary companies alone, but never include the parent company’s financial statements alone.