Consolidations

Consolidation is the accounting process of presenting a parent and the entities it controls as one reporting entity, so the statements show what the group owns, owes and earns outside itself rather than inside itself. Balances and transactions between members are eliminated, and the result is read as though the parent and the entities it controls were a single company. Consolidations, in the plural, is the ordinary name for the work, because the group has to be rebuilt from the members’ separate books every reporting period.

Who Has to Consolidate

The test is a controlling financial interest, and there are two routes to it. Which route applies is settled first. After a reporting entity has determined that it holds a variable interest, it decides whether the legal entity is a variable interest entity or a voting interest entity, and the voting interest guidance reaches only entities that are not in the scope of the variable interest entities subsections (FASB Accounting Standards Update 2015-02, the General Note to Section 810-10-05 and paragraph 810-10-15-10).

The Voting Interest Route

For legal entities other than limited partnerships, the usual condition for a controlling financial interest is ownership of a majority voting interest, so ownership by one reporting entity, directly or indirectly, of more than 50 percent of another entity’s outstanding voting shares is a condition pointing toward consolidation, and the power to control may also exist with a lesser percentage, for example by contract, lease, agreement with other stockholders, or court decree (FASB Accounting Standards Update 2015-02, paragraph 810-10-15-8). For limited partnerships the parallel condition is ownership of a majority of the partnership’s kick-out rights through voting interests, which the standard treats as analogous to the voting rights held by a corporation’s shareholders (paragraph 810-10-15-8A).

Owning the majority does not settle it on its own. A majority-owned subsidiary is not consolidated if control does not rest with the majority owner, for instance where the subsidiary is in legal reorganization or in bankruptcy, where it operates under foreign exchange restrictions, controls or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control it, or where approval or veto rights granted to a noncontrolling shareholder restrict the majority holder’s powers over the investee’s operations or assets in certain respects (FASB Accounting Standards Update 2015-02, paragraph 810-10-15-10).

The Variable Interest Entity Route

Some entities are controlled through arrangements that do not run on votes at all, and those are evaluated under a separate model. A legal entity is subject to the variable interest entity guidance if, by design, any of three conditions exists. The first is that its total equity investment at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. The second is that the holders of that equity at risk, as a group, lack any one of three characteristics: the power, through voting rights or similar rights, to direct the activities that most significantly impact the entity’s economic performance, the obligation to absorb its expected losses, and the right to receive its expected residual returns. The third treats those holders as lacking that first characteristic where the voting rights of some investors are not proportional to their obligations to absorb expected losses or their rights to receive expected residual returns, and substantially all of the entity’s activities either involve or are conducted on behalf of an investor with disproportionately few voting rights (FASB Accounting Standards Update 2015-02, paragraph 810-10-15-14).

The reporting entity that consolidates such an entity is called its primary beneficiary, and the condition is stated as a pair rather than as a judgment call. A reporting entity is deemed to have a controlling financial interest in a variable interest entity if it has both of the following characteristics: the power to direct the activities that most significantly impact the entity’s economic performance, and the obligation to absorb losses that could potentially be significant to the entity or the right to receive benefits from it that could potentially be significant (FASB Accounting Standards Update 2015-02, paragraph 810-10-25-38A). Power without the exposure does not consolidate, and exposure without the power does not either.

The Private Company Election

A private company may elect not to apply the variable interest entity guidance to legal entities under common control, including common control leasing arrangements, if both the parent and the legal entity being evaluated for consolidation are not public business entities. Three conditions ride with it. The election is an accounting policy that applies to all current and future common control entities meeting the criteria rather than to selected ones, the company still applies the rest of the consolidation guidance and particularly the voting interest guidance unless another scope exception applies, and detailed disclosures about its involvement with and exposure to the entity are required (FASB Accounting Standards Update 2018-17). For a private group whose operating company rents its building from a commonly owned entity it holds no voting interest in, that election decides whether the building entity appears in the group’s statements at all.

What Consolidation Actually Removes

In preparing consolidated statements, intercompany balances and transactions are eliminated, and the list runs to open account balances, security holdings, sales and purchases, interest and dividends; because the statements rest on the assumption that they represent a single economic entity, they do not include gain or loss on transactions among the entities in the group, and any intercompany profit or loss on assets remaining within the group is eliminated as well (FASB Statement No. 160, Accounting Research Bulletin No. 51 paragraph 6).

Say a parent charges a subsidiary a management fee during the year, and part of that fee is still unpaid at the reporting date.

Management fee charged by the parent to the subsidiary:      60,000
Portion of that fee unpaid at the reporting date:            15,000

                          Parent        Sub    Combined   Eliminations   Consolidated
Revenue                1,200,000    400,000   1,600,000       (60,000)      1,540,000
Operating expenses       900,000    350,000   1,250,000       (60,000)      1,190,000
Net income               300,000     50,000     350,000              -        350,000

Accounts receivable      180,000     40,000     220,000       (15,000)        205,000
Accounts payable         110,000     35,000     145,000       (15,000)        130,000

Net income lands in the same place before and after the elimination, because the fee was revenue to one member and an expense to another in equal amount. Revenue and operating expenses both fall, so every margin read off the consolidated statements differs from the margin read off a simple sum of the members. The receivable and the payable fall together too, since a group cannot owe itself.

Not everything the consolidated statements carry belongs to the parent. The portion of a consolidated subsidiary’s equity the parent does not own is a noncontrolling interest, and it is reported in the consolidated statement of financial position within equity, separately from the parent’s equity (FASB Statement No. 160, Accounting Research Bulletin No. 51 paragraph 26), and enterprise value adds it back when it prices the whole consolidated operating business.

How Consolidations Run in a Firm’s Close

Each entity closes its own books and produces its own trial balance, and the consolidation is built on top of them. Elimination entries are not posted to any member’s ledger. They live on the consolidation worksheet, they do not carry themselves forward, and the ones that touch balance sheet accounts have to be made again every period for as long as the underlying item stays inside the group. That is what turns consolidation into recurring work rather than a one-time exercise, and it sits on the same critical path as the rest of the month-end close.

A difference in fiscal periods between a parent and a subsidiary does not by itself justify leaving the subsidiary out, and where the difference is not more than about three months it is usually acceptable to use the subsidiary’s own statements for its own fiscal period, with recognition given by disclosure or otherwise to the effect of intervening events that materially affect financial position or results (FASB Statement No. 160, Accounting Research Bulletin No. 51 paragraph 4). Consolidated statements also have to disclose the consolidation policy being followed, which in most cases is apparent from the headings or other information in the statements and otherwise needs a footnote (FASB Statement No. 160, Accounting Research Bulletin No. 51 paragraph 5).

The Book Group and the Tax Group Are Not the Same Population

A group that consolidates for financial reporting does not automatically file one federal income tax return, and the two populations are drawn by different tests. An affiliated group of corporations has the privilege of making a consolidated return in lieu of separate returns, on the condition that all corporations which at any time during the year have been members consent to the consolidated return regulations prescribed under section 1502 (26 U.S.C. 1501). Privilege is the statute’s own word. The default is a separate return for each corporation, and the consolidated return is an election on top of it.

The tax test narrows the population in two ways at once. An affiliated group means one or more chains of includible corporations connected through stock ownership with a common parent that is itself an includible corporation, and the ownership has to meet an 80-percent voting and value test: at least 80 percent of the total voting power of the corporation’s stock, and a value equal to at least 80 percent of the total value of that stock (26 U.S.C. 1504(a)). Includible corporation then excludes corporations exempt from taxation under section 501, insurance companies subject to taxation under section 801, which a separate provision can bring back in, foreign corporations, regulated investment companies and real estate investment trusts, a DISC, and an S corporation (26 U.S.C. 1504(b)).

Three ordinary structures pull the two groups apart. A domestic subsidiary a parent controls without reaching that ownership threshold consolidates on the books and still files its own return. A wholly owned foreign subsidiary consolidates on the books and, as a foreign corporation, is not an includible corporation, so its income stays outside the consolidated return. A variable interest entity consolidated because the parent is its primary beneficiary can sit outside the affiliated group entirely, since the affiliated group is defined by stock ownership and the consolidation was not. One narrow election cuts against the foreign case. A domestic corporation owning or controlling, directly or indirectly, 100 percent of the capital stock of a corporation organized under the laws of a contiguous foreign country, and maintained solely for the purpose of complying with that country’s laws as to title and operation of property, may at its option have that foreign corporation treated as a domestic corporation for the purpose of the subtitle (26 U.S.C. 1504(d)).

Mechanically, the consolidated return is made on Form 1120 for the group by the common parent or the group’s agent, with Form 851, the affiliations schedule, attached, and for the first consolidated year each subsidiary must execute a Form 1122, authorization and consent of subsidiary corporation to be included in a consolidated income tax return, which the group attaches to the return either executed or as unsigned copies with the signed originals retained (Treasury Regulation section 1.1502-75(h)). That first-year form is not required for a year in which the group filed or was required to file a consolidated return for the immediately preceding year, and the stickiness runs the other way too: a group that filed one for the preceding year is required to keep filing unless it has an election to discontinue under that regulation (Treasury Regulation section 1.1502-75(a)).

The elimination habit does not carry across either. The consolidated return regulations treat the selling member and the buying member as separate entities for some purposes and as divisions of a single corporation for others, so the amount and location of the items are determined on a separate entity basis while their timing, character, source and other attributes are redetermined to produce the effect of transactions between divisions, and a member’s gain on a sale of property to another member is not taken into account until the buyer sells that property to a nonmember (Treasury Regulation section 1.1502-13(a)). Book eliminations remove the transaction. The tax rules mostly move it in time. Whether the group’s provision follows the book group or the tax group is a separate question the income tax standard answers, and the income tax provision and deferred tax assets hold that ground.

What Consolidation Is Not

It is not what a reporting entity does when it holds an interest that gives it influence over an investee without control. There the investment stays on one line and the reporting entity’s share of that investee’s earnings reaches the income statement through its own caption rather than through the revenue and expense lines, ground net income already covers. The practical tell is the income statement: a consolidated subsidiary’s revenue and expenses appear line by line, and an unconsolidated investee’s results arrive as a single number.

Common Questions

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