After more than four decades with only minor revisions, the past 15 years have seen a rapid evolution in the reporting requirements for consolidated financial statements. Here, we’ll take a look at the current criteria for reporting your consolidated financial results.
The Importance of Financial Consolidation
Financial consolidation can play an important role in your organization’s corporate performance strategy. Companies often use the term consolidation more generally to describe the collective financial reporting of their entire business. However, the Financial Accounting Standards Board (FASB) defines consolidated financial statements as the financial reporting of an entity consisting of a parent company and its affiliated legal entities.
Consolidated financial statements combine the financial results of a controlling parent company’s affiliated entities into a single source of truth, and they represent an important reporting tool for any company with multiple divisions or subsidiaries.
There are few consolidation accounting requirements for private companies, but publicly traded companies must prepare their consolidated financial results to meet the standards of the FASB’s generally accepted accounting principles (GAAP). Now let’s explore in more detail the requirements for consolidated financial reporting.
When to Consolidate
The decision to file consolidated financial statements is typically made on an annual basis. The factors influencing this decision will differ for private and publicly traded entities.
Private companies usually decide whether to create consolidated financial statements on a year-to-year basis. The decision is dictated by the possibility of tax advantages from filing an unconsolidated versus a consolidated income statement for that tax year.
In contrast, public companies often consider longer time horizons when deciding whether to create unconsolidated or consolidated financial statements. However, the choice of when to consolidate is more strictly controlled by GAAP reporting requirements.
Evolution of Reporting Requirements
Guidance for consolidation accounting has undergone an evolution over the past 60 years. The first formal requirement for consolidated financial statements was created in 1959. Accounting Research Bulletin 51 (ARB 51), later codified in Accounting Standards Codification Topic 810 (ASC 810), established the idea that consolidated financial statements are more relevant than individual financial statements when a reporting entity has a controlling interest in another legal entity. ARB 51’s major reporting criteria for consolidated financial statements have largely survived, with some modifications.
Over the next four decades, not much changed in the way publicly traded companies were required to report their consolidated financial results. However, the Enron scandal at the turn of the 21st century sparked a new leap forward in the FASB’s consolidation reporting requirements.
In the late 1990s and early 2000s, public companies began avoiding consolidated financial reporting requirements by structuring their legal entities in a way that separated financial interest from voting rights. These tactics allowed the energy company Enron to mislead investors and regulators by hiding significant amounts of debt and toxic assets within special-purpose entities. The company’s bankruptcy in 2001 and resulting congressional hearings in 2002 hastened the creation of a new consolidation framework in the form of FIN 46(R), introduced by the FASB in 2003.
Today, reporting requirements continue to evolve. The most recent updates (ASU 2018-17) went into effect at the end of 2019.
Criteria for Filing Consolidated Financial Statements
Generally, financial consolidation is required when an entity has a direct or indirect controlling financial interest in another entity. Established by ARB 51, this is referred to as the voting interest entity model. The FASB defines a controlling financial interest as an investment of 50 percent or more in voting equity. This model assumes that the controlling entity would stop its subsidiaries from making transactions or decisions that are not in the best interest of the parent company or controlling group.
However, companies have devised complex strategies to organize their affiliated legal entities and bypass the requirements of the VOE model. As a result, an investing parent company can have a controlling interest without necessarily retaining a majority of voting rights or ownership.
To address these types of arrangements, the FASB created the variable interest entity (VIE) model. Established by FIN 46 in direct response to the Enron scandal, the VIE model requires a reporting entity to claim a controlling financial interest when voting rights may not accurately indicate which party should consolidate a legal entity. You should consider an affiliated entity a VIE if it meets any of the following criteria:
- The entity does not have a sufficient equity investment at risk.
- The equity investors at risk lack a controlling financial interest.
- The entity conducts the majority of its activities on behalf of an investor with disproportionately few voting rights.
Reporting Consolidated Financial Statements
You’ve made the decision to consolidate your financial reporting and determined how you’ll classify your organization’s different affiliated legal entities. Now it’s time to consider how you’ll prepare your consolidated financial statements.
There are strategies you can adopt to streamline your consolidation process, but it’s important to understand what data your financial team needs to collect, analyze, and include in your organization’s reporting. A comprehensive consolidated financial statement should contain:
- Consolidated statement of profit or loss: a statement of profit or loss as well as other comprehensive income for the reporting period
- Consolidated statement of income: a statement of the financial position at the end of the reporting period
- Consolidated balance sheet: a statement of assets, liabilities, and shareholders’ equity
- Consolidated statement of changes in equity: a reconciliation of the beginning and ending balances in equity during the reporting period
- Consolidated statement of cash flow: a statement of net cash flow made through ongoing operations and external investments
- Notes to the financial statement: additional information on risk, group structure, and how values were calculated
Considerations for Multinationals
Organizations operating in a country outside the U.S. will have additional reporting considerations. Aside from the FASB’s GAAP framework, multinational corporations must follow the International Accounting Standards Board’s International Financial Reporting Standards (IFRS).
Although there are many similarities between U.S. GAAP and IFRS, there are also some important differences. In the context of financial consolidation, IFRS principles differ significantly enough that you may have to deconsolidate or consolidate entities that were not consolidated under U.S. GAAP.
The U.S. generally accepted accounting principles rely on the binary system of VOE versus VIE. In contrast, the International Financial Reporting Standards focus on indicators of control. Control is assumed when a parent entity holds more than half of an affiliated entity’s voting power. However, in cases where control isn’t so obvious, the requirement for consolidation is based on a holistic assessment of relevant factors such as the allocation of risks and benefits between the parties.
The International Financial Reporting Standards provide indicators to help you assess when consolidation is required. Generally, consolidation is required under the IFRS when your organization is exposed to variable returns from another entity and has enough power over that entity to affect its returns. If your organization operates internationally, you’ll also need to consider potential data gaps to comply with IFRS informational and disclosure requirements.
Transform Your Consolidation Accounting
Financial consolidation creates a single source of truth for companies structured with multiple subsidiaries or other affiliated entities. Private companies may choose to consolidate their financial statements to improve their corporate decision-making or gain tax advantages, but it’s a strict requirement for publicly traded companies. To stay compliant, make sure your financial team is up to date on recent updates to the U.S. GAAP reporting requirements.
Consolidation accounting is a time-intensive undertaking, but the right financial consolidation software can help you create your consolidated financial statements faster. Want to spend less time creating financial reports and more time identifying trends, threats, wins, and opportunities from your data? Longview can accelerate your consolidation processes and transform your office of the CFO. Visit our Consolidation Resource Center to learn more and start streamlining your financial consolidation process today.