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Importance of consolidated financial statements

INTRODUCTION

Consolidated financial statements report the financial results of the parent company and all of its

subsidiary companies in one combined report. Some companies own just one subsidiary, while

others own many subsidiaries. The consolidated financial statement includes just one set of

financial results. As each subsidiary reports its financial results to the parent, the accounting staff

at the parent company gathers the individual financial results, eliminates intercompany financial

transactions and consolidates the numbers into one statement. Several benefits exist for companies

who create consolidated financial statements.

Consolidated financial statements combine the balance sheets, income statements and cash flow

statements of two or more companies or business units. They are often presented for companies

that have one or more subsidiaries to show an overview of the entire operation. During the

consolidation process under generally accepted accounting principles, activity between the

companies disappears. A parent's investment in its subsidiary would be removed along with the

matching equity on the subsidiary's books. Any inter-company sales would be erased as would the

related cost of goods sold on the subsidiary's income statement. Consolidated financial statements

can give readers a misguided sense of profitability and financial stability in the absence of non-

consolidated information.

The following are some usefulness of consolidated financial statement:

1. Considerations

Without consolidated financial statements the process of evaluating a company for investment or

financing purposes would be a long complex affair that might altogether miss important assets or

liabilities. In fact, many of the arguments that occur between company management, accounting

and auditing at year end involve how the consolidation of reports should be done in order to give

the most accurate picture of the company's financial health. It is the auditor's job to make sure this

consolidation of accounting reports accurately reflects the true condition of the company.

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2 Significance

Growing a company often involves buying out the competition to acquire their customers and

expanding business through adding new products, services and technology. These additions to a

company's offering line usually means purchasing smaller companies that service particular niches

through their own product lines or technologies. The subsidiary companies normally continue to

operate as separate companies under the control of the parent company but according to accounting

rules each must maintain separate accounting records. These separate accounting records are then

consolidated with the parent company's accounting records to produce the consolidated finances.

3 Hides Inter-company Sales

All inter-company transactions are removed in a consolidation. On one hand, this presents a truer

view of the companies by showing only financial activity with non-related parties. However, it also

hides the level of inter-company transactions. If related companies spend most of their time and

resources selling products or services in the group, an outside investor will not be able to assess

transfer prices or profit-shifting in the group. Both of these things can be manipulated by

companies and can affect income taxes. Consolidation hides the extent of the inter-company

activity.

4. Function

It would be difficult for an investor or financial analyst to gather together all the accounting reports

of a parent company and its many subsidiaries in order to get an idea of the financial health of the

total enterprise, so parent companies are now required to report their finances on a consolidated

basis. Occasionally the parent will make a separate report of its own finances, but that cannot stand

alone and must be accompanied by the consolidated report.

5. Benefits

The ultimate benefit of consolidated financial statements should be ease of understanding and

analysis of a company's financial condition for investors, creditors, vendors and anyone else who

needs to know how secure the company is with respect to being able to pay its bills and continue as

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a profitable enterprise. However, a more sinister benefit of consolidated finances is that they can be

manipulated to hide financial problems. It is extremely difficult to ascertain from these statements

whether there are hidden problems and exactly where they are in the enterprise. The FASB

(Financial Accounting Standards Board) regularly visits this subject to correct definitions and

requirements that might serve as loopholes for companies wishing to hide losses and liabilities.

The IASB (International Accounting Standards Board) is also working to create definitions and

rules that will make evaluation easier and more reliable when examining the financial reports of

foreign companies and companies with offshore subsidiaries.

The following are some limitations of consolidated financial statements:

1. Lack of Subsidiary Information

The nature of consolidated financial statements is that a group of companies is viewed as one

entity. By this assumption's nature, the details of the individual companies are not presented. In

some cases, this is not important, as some subsidiaries may not be material to the entire company's

operations and results. In other cases, the amalgamation of financial results can hide unprofitable

subsidiaries and ventures. While the company in whole may be performing well, consolidated

statements may not show the entire picture.

2. Elimination of Intercompany Transactions

Generally accepted accounting principles require the elimination of intercompany transactions

upon consolidation. Because of this rule, investors are unable to ascertain the flow of funds

between subsidiaries. This could be important in determining which sections of the company are

viable in the long term. Furthermore, in situations where subsidiaries operate using different

functional currencies, these eliminations can lead to complex accounting and tax issues that may be

in accordance with accounting principles, but may be confusing to even seasoned investors.

3. Higher Group Materiality

When looking at a company on a consolidated basis, the threshold for determining if accounting

misstatements are material is generally higher. For example, if a company had 10 subsidiaries that

each had $1 million in annual sales, a $10,000 sale would be more important to those subsidiaries

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on an individual basis than to the group as a whole. Because of this, companies and auditors need

to implement controls to ensure that the financial statements are fairly presented taken as a whole.

This may mean that companies need to reconsider an appropriate level of accuracy in the financial

statements to reflect an acceptable amount of misstatement. Many times this amounts is between

the subsidiary and group level of accuracy.

4. Significant Influence vs. Control

A major limitation in the presentation of consolidated financial statements is the creation of

loopholes related to the consolidation of joint ventures, variable interest entities, and other special

purpose entities. While revisions in accounting standards have started to address these issues, the

rules of consolidation have allowed unscrupulous companies to hide billions of dollars of debt

from investors over the last couple of decades, by creating entities that they do not directly control,

but only influence. While the accounting for these entities is complex, investors should be aware

that the phenomenon exists and should be vigilant if the performance of their investment appears

too good to be true.

5. Misconceptions

Consolidated financial statements do not always give a more accurate picture of the financial

health of an enterprise because the individual accounting reports from the subsidiaries do not show

up anywhere but in the notes section of the consolidated finances. This makes it possible to hide

problems in the subsidiary reports, which is how Enron managed to hide the losses and liabilities

some of its failed projects generated. It just buried them in obscure subsidiaries created for the

purpose of hiding certain financial problems.

References:www.ehow.com

investopedia.com

http://www.ehow.com/http://www.ehow.com/http://www.ehow.com/

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