Consolidated Financial Statements

Many firms find it advantageous to organize as a set of separate legal entities (companies). For example, a firm may separately incorporate the various components of its business to limit its total legal liability or to take advantage of corporate tax regulations. Multinationals are often required by the countries in which they do business to set up a separate company. Thus, the typical multinational comprises a parent company and a number of subsidiary companies located in different countries, most of which are wholly owned by the parent. However, although the subsidiaries may be separate legal entities, they are not separate economic entities. Economically, all the companies in a corporate group are interdependent. For example, if the Brazilian subsidiary of a US parent company experiences substantial financial losses that suck up corporate funds, the cash available for investment in that subsidiary, the US parent company, and other subsidiary companies will be limited. Thus, the purpose of consolidated financial statements is to provide accounting information about a group of companies that recognize their economic interdependence.

Transactions among the members of a corporate family are not included in consolidated financial statements; only assets, liabilities, revenues, and expenses with external third parties are shown. By law, however, separate legal entities are required to keep their own accounting records and to prepare their own financial statements. Thus, transactions with other members of a corporate group must be identified in the separate statements so they can be excluded when the consolidated statements are prepared. The process involves adding up the individual assets, liabilities, revenues, and expenses reported on the separate financial statements and then eliminating the intragroup ones. For example, consider these items selected from the individual financial statements of a parent company and one of its foreign subsidiaries: 

	Parent			Foreign Subsidiary
Cash		$1,000		$250
Receivables		3,000*		900
Payables		300		500*
Revenues		7,000		5,000
Expenses		2,000		3,000**

^*Subsidiary owes parent $300.  ^**Subsidiary pays parent $1,000 in royalties for products licensed from parent.  The $300 receivable that the parent includes on its financial statements and the $300 payable that the subsidiary includes on its statements represent an intragroup item. These items cancel each other out and thus are not included in consolidated financial statements. Similarly, the $1,000 the subsidiary owes the parent in royalty payments is an intragroup item that will not appear in the consolidated accounts. The adjustments are as follows:

	Eliminations
	Parent	Subsidiary			Debit	Credit		Consolidated
Cash	$1,000		$250					$1,250
Receivables	3,000*		900			$300		3,600
Payables	300		500*		$300			500
Revenues	7,000**		5,000			1,000		11,000
Expenses	2,000		3,000**		1,000			4,000

^*Subsidiary owes parent $300.  ^**Subsidiary pays parent $1,000 in royalties for products licensed from parent.  Thus, while simply adding the two sets of accounts would suggest that the group of companies has revenues of $12,000 and receivables of $3,900, once intragroup transactions are removed from the picture, these figures drop to $11,000 and $3,600, respectively.

Preparing consolidated financial statements is becoming the norm for multinational firms. Investors realize that without consolidated financial statements, a multinational firm could conceal losses in an unconsolidated subsidiary, thereby hiding the economic status of the entire group. For example, the parent company in our illustration could increase its profit merely by charging the subsidiary company higher royalty fees. Since this has no effect on the group's overall profits, it amounts to little more than window dressing, making the parent company look good. If the parent does not issue a consolidated financial statement, however, the true economic status of the group is obscured by such a practice. With this in mind, the IASC has issued two standards requiring firms to prepare consolidated financial statements, and in most industrialized countries this is now required.