What is an unconsolidated subsidiary?
It is a subsidiary of a parent company whose individual financial statements have not been included in joint statements issued for public use by a parent company. Often such subsidiary companies appear as an investment in the consolidated statements of account, precisely the balance sheet. Another way of identifying unconsolidated subsidiaries is that the parent company does not have a controlling stake. This can become a reason why a company may be treated as an unconsolidated subsidiary. For example, the parent company may be exercising temporary control over the subsidiary, or both parents' and subsidiary's business operations may be significantly different.
- Financials of an unconsolidated subsidiary, although owned parent company, do not appear in the consolidated financial statements of a company.
- Instead of appearing as part of the parent, unconsolidated subsidiaries appear as investments on the parent group's consolidated financial statements.
- An unconsolidated subsidiary can be accounted for under the equity method or at historical cost.
Frequently Asked Questions (FAQ)
Why do companies have unconsolidated subsidiaries?
A company may have unconsolidated subsidiaries based on few reasons-
- It may not be under the permanent control of the parent group.
- The business operations of parent and unconsolidated may be unrelated and thus difficult to consolidate.
- Both parent and unconsolidated subsidiaries may be subject to different accounting treatments as per regulations.
- The parent company may be having less than a 50% ownership stake in the subsidiary.
There is a catch here; the investment must be above 20% as only then the parent company will exercise control on the subsidiary.
Often, parent companies themselves create unconsolidated subsidiaries. A variety of reasons may exist for doing so. Say, for example, to split costs, segregate revenue streams from diversified business operations or to be able to enjoy profits from special projects undertaken by the unconsolidated subsidiary.
Also, if the business of the unconsolidated subsidiary is noticeably bigger and if consolidated may not get reflected well, the parent company will possibly not consolidate it. Therefore, it will be a good decision for investors if seen from a reporting point of view.
Sometimes reasons for keeping a subsidiary's books separate may be the geopolitical or economic risks it is exposed to. For example, it often happens with MNC companies that have operations spread across the world. In such cases, the accounting choice of keeping an entity's reporting separate may be an apt choice. However, it doesn't make sense to show such subsidiaries beyond investment in consolidated financial statements unless risk exposure extends to core business, even from an accounting and reporting point of view.
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How are unconsolidated subsidiaries reported?
In the footnotes of consolidated financial statements, companies often describe how unconsolidated subsidiaries are treated reported. Here the accounting treatment applied is elucidated. Typically, unconsolidated subsidiaries are established for investing in a company's operations like joint ventures or special purpose entities or temporary companies established to keep revenue and expenses of projects separate from their finances.
As per International Financial Reporting Standard (IFRS 10) on consolidated financial statements, an investment entity needs to pre-specify if it wants exclusion from consolidation. Only then it is shown as an investment in a subsidiary. The reported number is often recorded as fair value through profit or loss.
Additional disclosures regarding significant assumptions in determining an investment entity's value are to be made. Also, details about specific transactions like transfer of funds, commitments, or any contractual arrangements are to be disclosed as per IFRS.
A company presenting consolidated statements is often referred to as a reporting company. The commonly followed accounting rules describe a passive investment as an entity where the reporting company holds 20% of a company's outstanding capital. A company has a significant stake in a business if the reporting company owns more than 20% but less than 50%. However, in practice, it is on the investing company's management to decide whether its interest is passive or influential. It is generally then checked and verified by a company's external auditors.
In the reporting company's financial statements, passive investments are shown at a market value of the shares held in the entity. However, another method called the equity method is used to show a stake in an influential investment.
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What is the equity method of reporting for unconsolidated subsidiaries?
Under the equity method, a parent company shows its investment in an unconsolidated subsidiary as a balance sheet asset. The value of the asset is often equal to the amount paid for shares in the target company. Thus, if the unconsolidated subsidiary reports profit, the value of investment rises. This rise is the parent company's share of the profit, determined from its ownership interest per cent.
Example of an unconsolidated subsidiary-
Let us consider a company, Big Ltd, having a 40% stake in a subsidiary, Small Ltd. Now, let's say Big Ltd's share is considered a controlling interest in Small Ltd, but it remains an unconsolidated subsidiary. Also, Small Ltd was created as a particular purpose vehicle for Big Ltd's new chemical refining business in a foreign country. Operations are to last only for two years.
Suppose Small Ltd records 10 billion dollars as profits for the year. Now since Big Ltd owns more than 20% of Small Ltd, it must record a share of earnings from Small Ltd in its financial statements. So now, Big Ltd will not consolidate the financial statements. Instead, it will just record four billion dollars (40% of 10 billion earned by Small Ltd) as earnings from investment in Small Ltd. This gain will not be part of operating income for Big Ltd. But the initial investment in Small Ltd will get reflected as an investment on the consolidated balance sheet issued by Big Ltd.