When large companies file financial reporting, they may need to consider whether they must file consolidated financial statements. In reporting for public companies, consolidation refers to the way that an organization presents itself. Many corporations have subsidiaries in which they have a partial or majority interest or ownership. The nature of these business relationships affects how they file regulatory reporting.
Consolidated financial statements present the financial information of the parent and subsidiaries together. The purpose of this approach is to present the various organizations as a single economic entity.
Consolidated financial reporting is required for most publicly traded companies, but it depends on how they exert influence over their subsidiaries. The rules guiding consolidated reporting come from generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), depending on the location of the parent company’s headquarters and its subsidiaries.
Companies that file consolidated reporting must include this information in regular reporting, such as 10-K and 10-Q filings, registration statements and M&A disclosures. The presentation of consolidated financial data is a key element of transparency for investors, because they can see how the company is doing as a whole. With this guide, companies will gain understanding about when they are required to file a consolidated financial statement and what to include for best results.
When Are Consolidated Financial Statements Required?
The companies that must file consolidated financial statements need to start by determining their roles with their subsidiaries. There are a few key terms to understand to be able to assess eligibility:
- Ownership: The percentage of ownership in company stock, equity or voting rights within a company
- Control: The degree of ability to control company decision-making, whether through stock or equity ownership or other means
- Voting Interest: Retaining a stake in company operations by vote, commonly through equity holdings
- Variable Interest: A degree of controlling interest that comes through contracts, not equity or stock holdings
Control determines the requirement more than merely ownership. Regulation S-X establishes the general presumption that parent companies with a majority voting interest or ownership should consolidate financial statements, using the voting interest model. Companies that do not have a majority control or interest in a subsidiary may still need to consolidate, but it depends on the nature of that control or interest.
Parent companies with contracts that constitute variable interest entities (VIEs) may also need to consolidate financial reports. In this arrangement, a company exerts control over another by the creation of contracts that dictate certain decisions by the subsidiary. There are a few exceptions to this rule. For example, if a company is a not-for-profit entity, they may not need to consolidate financial statements with a partner.
Key Components of Consolidated Financial Statements
A consolidated financial report involves a number of elements. Companies provide much of the same information that they would for normal financial reporting, with a few notable inclusions:
- Consolidated balance sheet
- Consolidated income statement
- Consolidated cash flow statement
- Consolidated statement of equity
The function of the consolidation is to present the company as a single entity, which it effectively is due to the amount of control that the parent exerts over the subsidiaries.
Because the company is treating itself as a single entity, this approach to financial reporting eliminates intercompany transactions from the consolidated results, such as sales, receivables or payables or dividends. This elimination is important for transparency, as the parent company cannot rely on an intercompany transaction to make one entity’s financial position look better in the face of flagging performance.
Since parent companies may control or own a significant percentage of a subsidiary, but not all of it, some discussion of noncontrolling interest may be required. A noncontrolling interest describes equity ownership that is not attributable to the parent, commonly referred to as a minority stake. The combined financial statements should identify the degree of minority ownership, especially if it changes over time.
Variable Interest Entities (VIEs)
So much of the requirement for consolidated financial reporting is related to ownership, but variable interest entities (VIEs) can play a role as well. Companies can exert control over each other in ways that do not require them to purchase stock or retain an equity stake. The creation of a VIE comes through the agreement of a legally enforceable contract that significantly affects the decision-making power of the subsidiary.
A range of industries use VIEs to facilitate business actions while keeping the two entities generally separate. For example, chain restaurants that rely on franchising allow the franchisee to leverage branding and other benefits in exchange for adherence to the company’s requirements. This type of contract would constitute a VIE, as would a joint venture, trust or partnership. Other industries that commonly use VIEs include real estate, financial services and structured finance.
The main goal of including VIEs in consolidated financial reporting is to shed light on the influence that companies exert over each other. VIE reporting has been somewhat murky in decades past, but updates to financial reporting requirements in recent years have added clarity. Public companies are required to identify VIEs in which they are the primary beneficiary, such as a franchisor that is the primary beneficiary of a franchisee relationship. They must include the nature and degree of their influence, as well as a consolidated balance sheet and other financial information necessary for a consolidated financial statement.
Consolidated Financial Statements in M&A Transactions
Mergers and acquisitions can change the nature of the relationship between companies, which may call for a re-evaluation of the requirements for consolidated financial statements. The SEC establishes a number of requirements for companies seeking a merger or acquisition, to reflect their current financial position prior to the change in ownership and pro forma financial information. Information required may include:
- Purchase accounting
- Fair value measurement at acquisition
- Goodwill recognition of intangible assets, if the purchase price is higher than the fair value estimation
- Significance tests
Much of the determination of requirements here depends on whether the merger or acquisition is considered significant. The SEC sets tests to help companies determine significance. These tests involve an assessment of the market value, proportionate share of the subsidiary and income tests.
A company filing an S-4 registration statement to complete an acquisition must include this assessment, along with pro forma financial information under Article 11 of Regulation S-X. This information provides critical data about transition plans and financial projections for the new entity or arrangement.
Disclosure Requirements for Public Companies
The SEC requires disclosures for specific reasons, even if they aren’t immediately clear. Every piece of financial data or discussion included in a financial report moves toward the goal of transparency for investors. Regulators scrutinize the information to look for obvious inaccuracies, vague assessments or inconsistencies. Public companies preparing a consolidated report should take special care when including the following details:
- Alignment between reporting segments
- Clarity in transactions between related parties
- Noncontrolling interests, especially those holding a significant stake
- VIE assessments in disclosures
- Changes to consolidation status, which is common when a parent takes a larger or lesser stake in a subsidiary
- Transparency in footnotes
The goal is for the information to be presented clearly, consistently and accurately. That way, investors can effectively assess the performance of companies where they hold shares.
Best Practices for Consolidation Compliance
Since consolidation is such a critical element of compliance for parent companies with subsidiaries, businesses should make the effort to ensure that they follow best practices when preparing and submitting reports. Perform the following tasks:
- Implement document controls and perform assessments annually.
- Maintain a schedule to eliminate intercompany details for compliance with SEC rules.
- Standardize internal controls for data collection and report preparation across subsidiaries, to minimize confusion or inaccuracies when the reports are consolidated.
- Automate and test workflows to consolidate information.
- Align enterprise resource planning and reporting systems.
- Conduct regular internal audits to ensure that systems are properly operating and teams understand how to comply with SEC guidelines.
Companies may need to make significant changes to data systems and processes to ensure compliance with consolidated financial statement requirements. Tools like corporate repository file management can help to streamline collaboration across teams.
Partner With DFIN for Accurate Financial Reporting
Creating disclosures with multiple entities can be complicated. Companies must consider whether they must include subsidiaries in consolidated reporting, along with all the complexities that consolidation adds to reporting workflows.
The use of financial reporting software is a key advantage for businesses looking to streamline tasks, improve transparency in SEC reporting and achieve compliance in a shorter period of time. DFIN’s solutions offer these benefits:
- Workflows that seamlessly integrate reporting frameworks with operational systems
- Drafting that allows for multi-team collaboration, with version controls that help preserve accuracy during internal review
- Alignment with XBRL tagging requirements, for readable online presentation to investors
- Secure document management that prevents unauthorized users from accessing sensitive data
- Audit-ready controls that increase internal transparency and simplify responses to SEC scrutiny
As a partner in financial reporting infrastructure, DFIN can help you streamline your annual report and other reporting requirements with precision and compliance.
