Companies are complex structures that represent a separate legal entity. Primarily, they issue shares that allow shareholders to become part-owners. Being a separate legal entity, companies have all the rights that other legal entities have. Therefore, companies can also buy shares from other companies as a part of their investment policies.
The accounting for investments is straightforward and usually falls under financial instruments. However, accounting standards also dictate companies account for their associates and subsidiaries differently. This treatment differs from the one used for financial instruments. The accounting for subsidiaries depends on the ownership percentage of the parent company. Before understanding that, however, it is crucial to define the term subsidiary.
What is a Subsidiary?
As mentioned, a company sells its shares to the public that become its part-owners. Usually, its owners include individuals who buy those shares and become their shareholders. However, it may also consist of other companies. When a company buys another company’s shares, it also becomes its shareholder. However, the underlying investment does not constitute a subsidiary in all circumstances.
A subsidiary is a company that falls under the ownership of another company, known as a parent or holding company. For a company to become a parent company, it is crucial to establish a relationship with the subsidiary. This relationship is known as the parent-subsidiary relationship. For it to exist, the parent company must hold above 50% of the subsidiary’s shares.
When a company holds more than 50% shares to another company, it becomes a parent company. Owning more than half of the subsidiary’s shares gives the parent control over its operations. This interest held by the parent company is known as a controlling interest. In some cases, parent companies may also own all (100%) of the subsidiary’s shares. In those cases, the subsidiary is known as a wholly-owned subsidiary.
Overall, a subsidiary is a company in which another company has a controlling interest. This controlling interest comes from owning more than 50% of shares in a company. In some cases, it may also involve having more than half the voting rights in the company. In general, however, the former criterion is enough to establish a subsidiary and a parent company.
What is the Consolidation Method of Accounting for Subsidiary?
The consolidation method of accounting for subsidiaries involves establishing a parent-subsidiary relationship. When a company owns more than 50% of the stocks to another company, it must treat the controlling interest as a subsidiary. Due to this relationship, the parent company must prepare consolidated financial statements.
The accounting for subsidiaries under the consolidation method includes various steps. It involves combining both the parent and subsidiary company’s financial statements. However, accounting standards may provide an exemption to this process in some circumstances. In most situations, however, the consolidation method for accounting for subsidiaries will apply.
The primary principle when it comes to the consolidation method is combining both companies’ financial statements. The responsibility of preparing these financial statements resides with the parent company. Usually, both companies also prepare individuals financial statements to facilitate the process. However, it is not mandatory to do so.
There are several steps involved in the preparation of consolidated financial statements, which are as follows.
- A parent-subsidiary relationship must exist between both companies.
- The parent company must replace the investment in the subsidiary with the subsidiary’s net assets.
- The parent company will cancel the cost of investment with the share capital and reserves of the subsidiary. Any difference between both figures will result in recognizing goodwill in the balance sheet.
- The parent company must calculate the non-controlling interest (NCI), and the group retained earnings. The NCI working is not required for wholly-owned subsidiaries as it will not exist.
- Both companies will combine their balance sheet and income statement figures to prepare consolidated versions.
The above steps involve a simplified process for accounting for subsidiaries using the consolidation method. In practice, the structure between both companies may be more complex. For example, both companies may transact with each other, which will make the process more complicated. Some companies may also have various subsidiaries or even associates, which affects the consolidation process.
Similarly, the above process assumes a straightforward parent-subsidiary relationship. In some cases, this relationship may be more complex. For example, a parent company will own a subsidiary company, holding a controlling interest in other companies. In these circumstances, the consolidation method of accounting for subsidiaries will become more complex.
What is the Equity Method of Accounting for Subsidiary?
The equity method of accounting for subsidiaries does not apply to subsidiaries. When a parent company establishes a controlling interest over a subsidiary, it must use the consolidation method. Sometimes, however, the interest that the investor company will have will not be
‘controlling’. Instead, it may involve an effective interest.
Effective interest is when a company owns 20% or more interest in a company. However, it must not include a controlling interest. Therefore, this interest effectively involves holding 20%-50% of another company. It is also known as a significant influence. As mentioned, this relationship will not form a parent-subsidiary structure. Instead, the underlying company in which the investor invests is known as an associate.
The equity method of accounting only applies to associate companies. This process does not involve the same steps as consolidation. Similarly, it does not require the investor to prepare consolidated financial statements. Therefore, it eliminates the need to account for the owned interest in companies by combining financial statements.
However, the equity method of accounting requires companies to account for associates only in consolidated financial statements. Therefore, a company must have at least one subsidiary and one associate to use the equity method. Primarily, this method involves recording the investment at cost. It also requires an adjustment for post-acquisition changes in the investor’s share of the associate’s net assets.
The parent company will include “investment in associate” within its non-current asset under the equity method. This item will consist of the cost of the investment and the group share of the post-acquisition reserves. Similarly, the income statement will also include a portion of the profit from associates. It will consist of the group’s share of the associate’s profit after tax. As mentioned, however, this will only apply to consolidated financial statements.
What are the journal entries for Accounting for Subsidiary?
The journal entries for accounting for subsidiaries is straightforward. When a company acquires an interest in another company, it will record it as an asset at cost. Companies may use various forms of compensation, for example, cash, bank, stock, etc. Once invested, the parent company will use the following accounting entries to record the investment.
|Investment in subsidiary/associate||XXXX|
|Cash or Bank etc.||XXXX|
For the subsidiary company, on the other hand, the accounting entries will be as follows.
|Cash or Bank etc.||XXXX|
The above double entries do not apply to any specific method. Therefore, these are not a part of the consolidated or equity method of accounting for subsidies. Instead, these are the entries that companies use to account for subsidiaries in general.
A company, ABC Co., purchases 52% of the shares of another company, XYZ Co. ABC Co. pays $30 million for this acquisition through the bank. Both companies must record this transaction in their respective books. For ABC Co., this process will give rise to the following journal entries.
|Investment in XYZ Co.||$30 million|
For XYZ Co., the journal entries will be as below.
|Common stock||$30 million|
Since ABC Co. acquired more than 50% of shares in XYZ Co., it will prepare consolidated financial statements. The primary reason behind this treatment is that 52% of shares constitute a controlling interest in XYZ Co. For 20%-50% interest, then the equity method of accounting would apply. However, it would also require ABC Co. to own another subsidiary.
Subsidiaries are companies in which a parent company has a controlling interest. It usually involves owning more than 50% shares in the subsidiary companies. When a parent company acquires a subsidiary, it must use the consolidation method to prepare its financial statements. If it owns 20%-50% shares in any other companies, it must account for them using the equity method.