Because of their separate legal status, a parent company and its subsidiaries keep independent accounts and prepare separate financial statements. However, investors are interested in the financial performance of the combined group and so this is reported as the group’s “consolidated” or “group” financial statements, which present the financial accounts as if they were from a single company.
Companies within a group often do business with one another. Raw materials and finished goods may be bought and sold between companies in a group; cash may also be lent by the parent company in order to finance operations or capital investments. These transactions appear in the financial accounts of both parties but need to be eliminated in the consolidated accounts; if not, then the combined companies would appear to have been carrying on more business than was actually the case. For example, suppose a subsidiary is lent US$1 million by its parent via a note payable. The balance sheets of the two companies would contain these lines:
| Parent company | Subsidiary company |
| Balance sheet | Balance sheet |
| Assets | Liabilities |
| Notes receivable | Notes payable |
| US$1m. | US$1m. |
In forming the consolidated accounts, these transactions would be entered for elimination on a work sheet in some fashion, such as the following:
Notes payable (subsidiary) US$1m. Notes receivable (parent) US$1m. to eliminate inter-company receivable and payable.
A parent company need not own 100 percent of a subsidiary in order to maintain control of it. In acquiring a new subsidiary company, the parent need only obtain more than half of the voting stock of the acquired company. The parent then has what is called a majority interest while the other owners have a minority interest. Elimination in the consolidated accounts is then carried out in proportion to ownership. This can be can be illustrated as follows for the balance sheet:
Predator company buys 80 percent of Prey company (as voting shares of stock). Predator has US$1,000,000 of stock and US$800,000 of retained earnings. Prey has US$100,000 of stock and US$50,000 of retained earnings.
Predator records the acquisition as:
| Investment in prey | US$120,000 |
| Cash | US$120,000 |
to record the acquisition of 80 percent of Prey.
The eliminations needed in preparing the consolidated accounts could be achieved as shown in Table 1.
The minority interest is recorded as shown in Table 2.
| Table 2 Recording of Minority Interest | |
| Shareholders’ equity | |
| Minority interest in prey | $30,000 |
| Common stock | $ 1,000,000 |
| Retained earnings | $ 800 ,000 |
| $ 1,830,000 |
Thus, the controlling stockholders of the combined companies have US$1,800,000 of equity and outside stockholders of the prey subsidiary have US$30,000 of equity.
If a subsidiary is formed by acquisition, this can be treated in the stockholders’ topics by two alternative accounting methods, called purchase and pooling of interests. The purchase method requires the assets of the acquired company to be reported in the topics of the acquiring company at their fair market value. The price actually paid will often be greater than the fair market value of the assets of the acquired company, since the value of the company lies in its trading capability not simply in the resale value of its fixed assets. Therefore, the financial accounting quantity called goodwill is created, equal to the excess of the purchase price over the sum of the fair market values of the assets acquired. Goodwill can be amortized over a period of years (this does not mean that the tax authorities in a particular country will allow tax deductions on these amortization expenses). In contrast, using pooling of interests, no goodwill is created and the as sets of both companies are combined in new topics at the same values as recorded in their separate topics; the total recorded assets and the total equity are unchanged.
It is useful to know what differences arise from the use of these alternative financial accounting treatments. In purchase accounting, amortization of goodwill reduces income shown on the stockholders’ topics. Also, the assets of the acquired company are put on the stockholders’ topics at the fair market value. Depreciation expense is increased, again lowering the income reported compared with pooling. However, the cash flows on acquisition are not affected by the choice of financial accounting method chosen and so neither the net present value of the acquisition nor taxes are affected.
