Consolidated Financial Statements: A Group as One Entity

Consolidated financial statements present a parent business and everything it controls as though the whole arrangement were one business. Every line of the subsidiary is added to the parent's, anything the two charged each other is taken out, and the share of the subsidiary belonging to outsiders is shown separately as a non-controlling interest. The result answers a question neither set alone answers: what does this whole group hold, owe and earn?

The reason consolidation exists has nothing to do with tidiness. A business that controls another business can move things between them at will. Picture a man running two counters on the same street, a stationery shop at the front and a small printing bench behind it. He can decide that the printing bench charges the shop Rs 40,000 a month for its work, or Rs 4,00,000, or nothing at all. Whichever he picks, the street bought exactly the same number of notebooks. So a reader handed the accounts of the printing bench alone is reading a document whose most important figure was set by the same person who wrote it. The parentThe business that controls another business. It keeps its own accounts as well, and separately presents the combined picture of itself and everything under its control. is in exactly that position, and consolidation is the response to it.

Consolidation removes the freedom to shift figures across an internal line, by treating both sides of the line as one entity and cancelling whatever crossed it. Cancelling what crossed the line is the whole point, and every mechanical step of a consolidation follows from it. Two businesses that are separate in law are described as one in the accounts, not because the law has changed, but because the reader's question is about the whole arrangement and the arrangement is what the internal transfers cannot flatter.

The sections below run from what triggers a consolidation, through the three mechanical steps worked on a small group, to why cancelling Rs 15,00,000 of revenue leaves profit untouched, the two places the outside share appears, and the two independent routes that reach the same closing group stake.

What are consolidated financial statements, and why do they exist?

A set of consolidated financial statementsOne set of accounts covering a parent business and every business it controls, prepared as though the whole arrangement were a single business. is one set of accounts covering a parent and every business under its control, prepared as though the whole arrangement were a single business with one bank account and one set of customers. A consolidated set is not a summary of the two sets, and it is not the sum of them either. A consolidated set is a third document, built from both. Neither set on its own tells a reader how big this business is or what it earned. The third document does.

Anjani Stationers, an invented business, prints school notebooks out of one small unit. At the start of its second year it bought 70 per cent of Chitra Binding, a workshop that stitches and covers notebooks, for Rs 21,00,000 in cash. Chitra Binding is now a subsidiaryA business that another business controls. Its own accounts continue to exist, and every line of them also appears inside the controlling business's combined statements., its founder keeps the other 30 per cent, and both companies carry on filing their own accounts exactly as before. Nothing was merged. Two boards still sit, two bank accounts still run, and two sets of statements are still prepared.

Consolidated statements do not replace either business's own accounts; they describe the line drawn around both of them. The line drawn around both is the single idea to hold on to. Almost every confusion about a group comes from imagining that consolidation dissolves the two companies into one. Consolidation dissolves nothing. A consolidation draws a boundary, adds up what is inside the boundary, and cancels anything that only ever crossed from one side of it to the other. Notice also that no such boundary existed in Anjani Stationers' first year, when there was no subsidiary at all. With no boundary, the first year's statements carry no investment line, no goodwill and no outside share. The group is something that appeared in year two, not something that was always there.

What makes one business a subsidiary rather than an investment?

ControlThe power to direct what a business does, whom it serves and how its resources are used, and to take the benefit of the results. A shareholding is evidence of it rather than the test itself., and not a percentage. The percentage is so visible that it looks like the rule, and mistaking it for the rule is the commonest error in reading a group. Control means the power to direct the activities of the business, the customers it serves and the use of its resources, together with exposure to the results of that direction. A shareholding is usually how that power arrives, so a large percentage is strong evidence of control. A shareholding is evidence, though, not the test.

An everyday version makes the difference obvious. A school runs a canteen through a caterer. The school fixes the menu, the opening hours and the prices, and it can end the arrangement at a month's notice. The caterer keeps a third of the takings. Asked who controls the canteen, nobody hesitates, and nobody reaches for a shareholding to answer it. Asked instead who takes a third of the money, the same people give a different and equally correct answer. Two questions, two answers, and reading a group means keeping them apart.

Control decides whether a business is consolidated at all, and the percentage only decides how the result is divided once it has been. Anjani Stationers has 70 per cent of Chitra Binding and appoints the majority of its board, so Chitra Binding is consolidated. Notice what that means in practice: 100 per cent of Chitra Binding's revenue, 100 per cent of its costs and 100 per cent of its assets go into the combined statements, not 70 per cent of them. The 70 per cent does no work at all at the adding stage. The percentage arrives later, at the very last step, when the combined result is divided between the shareholders of Anjani Stationers and the founder who still holds the other 30 per cent.

How are two sets of statements actually combined?

In three mechanical steps, always in the same order. Add every line together. Take out anything the two charged each other. Then show the outside share separately. Each step is arithmetic rather than judgement, each one produces figures that can be checked, and none of them can be sensibly done before the one in front of it.

Consolidation is three mechanical steps in a fixed order, and every consolidated figure a reader sees is the output of one of them. Step one adds: revenue of Rs 2,70,00,000 and Rs 40,00,000 becomes Rs 3,10,00,000, profit of Rs 30,00,000 and Rs 10,00,000 becomes Rs 40,00,000, and assets of Rs 1,80,00,000 and Rs 47,00,000 becomes Rs 2,27,00,000. Step two takes out the internal charge and the internal holding. Revenue comes down to Rs 2,95,00,000 and assets to Rs 2,09,50,000. Step three divides the corrected totals, so profit of Rs 40,00,000 is shown as Rs 37,00,000 and Rs 3,00,000, and the closing stake of Rs 1,59,50,000 is shown as Rs 1,49,00,000 and Rs 10,50,000.

The order is not a matter of taste. Dividing before cancelling would split a revenue figure that still contained Rs 15,00,000 the group had charged itself, and both halves of the split would then be wrong in a way that no later step corrects. Add, cancel, divide. Every consolidated set ever opened was built in that sequence, whatever the software looked like on the way.

Why is what the two charged each other removed?

Because a group selling to itself has not sold anything. Chitra Binding did Rs 15,00,000 of binding work for Anjani Stationers during the year and billed for it properly, and Anjani Stationers recorded the same Rs 15,00,000 as a cost of making notebooks. Both entries are correct in both sets of accounts. Seen from the boundary, though, nothing left the group. A household version: taking Rs 5,000 out of one pocket and putting it in the other has not made the household better off, however carefully both movements were recorded.

Consolidated revenue is Rs 2,95,00,000 rather than Rs 3,10,00,000. Rs 15,00,000 of the combined total was the group billing itself. Without that cancellation, called an eliminationThe removal of a transaction or balance that exists only between businesses inside the same group, so that the combined statements report only what happened with the outside world., any group could inflate its apparent size at will by moving work between its own companies, and a group with four companies in a chain could report the same rupee of trading four times. The rule that prevents it is blunt and mechanical: if a transaction has one side inside the boundary and the other side also inside the boundary, then for the group it never happened.

Now the part that surprises most first readers. Chitra Binding's revenue from the binding work was a cost to Anjani Stationers, so the elimination takes Rs 15,00,000 out of revenue and the same Rs 15,00,000 out of costs. Combined revenue falls from Rs 3,10,00,000 to Rs 2,95,00,000 and combined costs fall from Rs 2,70,00,000 to Rs 2,55,00,000. Rs 2,95,00,000 less Rs 2,55,00,000 is Rs 40,00,000, exactly the profit the two businesses reported between them before anything was cancelled. The group got smaller, not poorer.

One assumption is doing work in that arithmetic. All the binding Chitra Binding did for Anjani Stationers went into notebooks that were sold on to schools within the same year, so none of that Rs 15,00,000 is sitting in closing stock at the year end. So the elimination removes an equal amount from revenue and from costs and leaves profit untouched. Had a quarter of those notebooks still been stacked in the unit on the closing date, a slice of Chitra Binding's profit would still be sitting inside the group's own stock rather than earned from anybody outside, and the elimination would have had to reach into profit as well.

The four positions of the control above, written out in full. With no step applied, two documents sit side by side: revenue of Rs 2,70,00,000 and Rs 40,00,000, profit of Rs 30,00,000 and Rs 10,00,000, assets of Rs 1,80,00,000 and Rs 47,00,000, stakes of Rs 1,42,00,000 and Rs 35,00,000. After step one, everything is added: revenue Rs 3,10,00,000, profit Rs 40,00,000, assets Rs 2,27,00,000, combined stakes Rs 1,77,00,000. After step two, the internal charge and the internal holding are cancelled: revenue Rs 2,95,00,000, profit still Rs 40,00,000, assets Rs 2,09,50,000, equity Rs 1,59,50,000. Rs 1,77,00,000 less the Rs 21,00,000 investment plus Rs 3,50,000 of goodwill gives the equity of Rs 1,59,50,000. After step three, the corrected totals are divided: profit of Rs 40,00,000 shows as Rs 37,00,000 and Rs 3,00,000, and equity of Rs 1,59,50,000 shows as Rs 1,49,00,000 and Rs 10,50,000. The position after step three is the published consolidated set, figure for figure.

Who is the non-controlling interest, and where does it appear?

Chitra Binding's founder still holds 30 per cent of the workshop, and that holding did not disappear when the consolidated statements were prepared. All of Chitra Binding's revenue, costs, assets and liabilities went into the combined totals, so those totals now include things that are only 70 per cent the group's. The non-controlling interestThe share of a subsidiary that belongs to shareholders other than the parent, shown on its own line so a reader can see which part of the group's earnings and stake is not theirs. is the line that says so.

Two cousins buy a delivery cycle together, one putting in seventy rupees of every hundred and the other thirty. Two different questions can be asked about the second cousin's position at the end of a year. How much of this year's earnings is theirs, and how much of the cycle itself is theirs? The two questions have different answers, and nobody would expect one number to serve for both.

The non-controlling interest appears twice, once as a share of one year's profit and once as a share of everything the subsidiary holds, and the two are worked out from different things. In the profit statement, Rs 3,00,000 of the group's Rs 40,00,000 belongs to the outside holder, being 30 per cent of Chitra Binding's Rs 10,00,000 for the year. The remaining Rs 37,00,000 belongs to the shareholders of Anjani Stationers. In the balance sheet, Rs 10,50,000 of the group's Rs 1,59,50,000 closing stake belongs to that same holder, being 30 per cent of Chitra Binding's closing net assetsWhat a business holds less what it owes. For Chitra Binding at the close, Rs 47,00,000 of assets less Rs 12,00,000 of liabilities, which is Rs 35,00,000. of Rs 35,00,000. One figure covers twelve months of earning. The other covers everything accumulated to the closing date. The two figures are not meant to match, and a reader who expects them to has confused a period with a position.

Every consolidated figure can be reached by two independent routes, and a consolidation that only works one way has been forced rather than described. Take the Rs 1,49,00,000 attributable to the shareholders of Anjani Stationers. Route one subtracts: the group's Rs 1,59,50,000 less the outside Rs 10,50,000. Route two builds: Anjani Stationers' own closing stake of Rs 1,42,00,000 plus 70 per cent of the Rs 10,00,000 Chitra Binding earned since it was bought, or Rs 1,42,00,000 plus Rs 7,00,000. Nothing links those two routes except the facts, and they agree to the rupee. Do the same with the outside share: 30 per cent of Rs 35,00,000 is Rs 10,50,000, and separately, the Rs 7,50,000 that was the outside share of Chitra Binding's Rs 25,00,000 of net assets on the day it was bought plus Rs 3,00,000 of this year's profit is also Rs 10,50,000. Agreement between two routes that share nothing but the facts is what checking a consolidation looks like.

Where does goodwill come from in a consolidation?

From subtraction, and from nowhere else. Anjani Stationers paid Rs 21,00,000 in cash for 70 per cent of Chitra Binding. On the day of the purchase, everything Chitra Binding held less everything it owed came to Rs 25,00,000, so 70 per cent of that, Rs 17,50,000, is the measurable share the buyer acquired. The price was Rs 21,00,000. The cash that left and the assets that arrived do not account for the whole price, so the Rs 3,50,000 between them has to sit somewhere on the consolidated balance sheet. The line it sits on is called goodwillThe amount by which the price paid for a business exceeds the share of its identifiable net assets acquired. It appears only on consolidation and is a difference rather than a valuation..

Goodwill is a residue rather than a valuation: Rs 21,00,000 paid against Rs 17,50,000 of net assets acquired leaves Rs 3,50,000 with nothing else to call it. Nobody measured Chitra Binding's reputation and arrived at Rs 3,50,000. The figure is what is left after everything measurable has been accounted for. Two buyers paying two different prices for identical businesses would therefore report two different goodwill figures for the same workshop. The extra Rs 3,50,000 bought something real enough: a workshop that already runs, stitchers who already know the work, and a machine already set up for notebook sizes. None of that has a separate measurable value, so it lands in the residue.

Two details are commonly fumbled. First, goodwill is measured against the share acquired and not against the whole business: the comparison is Rs 21,00,000 against Rs 17,50,000, not against Rs 25,00,000. Second, the other Rs 7,50,000 of those net assets, being 30 per cent of Rs 25,00,000, was never bought at all and stays with the founder. The outside share on the balance sheet begins its life there. The year's Rs 3,00,000 added to that Rs 7,50,000 gives the Rs 10,50,000 that appears at the close.

What do Anjani Stationers' consolidated statements look like in full?

Set out in full, one line at a time, the three steps stop being a procedure and become a document. The first table below reads across rather than down: each row starts with what Anjani Stationers reported, adds what Chitra Binding reported, takes out what crossed the boundary, and ends with what the group publishes. Every figure in the last column has been produced by the three steps and by nothing else.

The balance sheet works the same way, with one extra move: the investment line disappears and what it stood for arrives in its place. Anjani Stationers holds Rs 1,80,00,000 of things, and Rs 21,00,000 of that is the investment in Chitra Binding. Leave the investment line in and add the workshop's own assets beside it, and the same holding would be counted twice over.

Now the part that turns arithmetic into a description. Every one of those group figures can be reached a second way, from a completely different direction, and if a second route disagrees then the consolidation is wrong somewhere. Work down the table below and notice that no row uses the same reasoning twice.

Five figures, ten routes, no disagreements. The strongest reason to trust a consolidated set is not that somebody signed it, but that its own internal arithmetic can be attacked from several directions and holds each time.

What does the consolidated picture show that neither set alone does?

Three things, and each of them is invisible in both of the underlying documents. The size of the trading actually done with the outside world, Rs 2,95,00,000 rather than Rs 2,70,00,000 or Rs 40,00,000. The earnings of everything under one management, Rs 40,00,000. And how much of those earnings will never reach the shareholders of the business at the top, the Rs 3,00,000 on the outside line. Neither Anjani Stationers' own accounts nor Chitra Binding's contain any of those three figures, anywhere.

Anything moved across the internal line is cancelled before the totals are struck, so the consolidated view is the only one that internal transfers cannot flatter. Go back to the printing bench behind the stationery shop. If the bench charges the shop Rs 4,00,000 instead of Rs 40,000, the bench's own accounts look four hundred thousand rupees better and the shop's look four hundred thousand rupees worse. The charge is cancelled on both sides before anything is added up, so the consolidated statements do not move at all, in either direction. Immunity to internal transfers is the property worth having, and it is why a reader who wants to know what a group actually did reaches for the consolidated set first.

The property has a limit. The consolidated set is not proof that the trading inside the group was priced sensibly, and it does not show which of the businesses inside the boundary earned the money. The consolidated set establishes only that whatever was priced internally has been taken out of the totals, a narrower and more useful claim.

What does an analyst do first with a group's consolidated statements?

Not read the totals. A consolidated set is not an idea people admire but a document people interrogate, and the interrogation follows a fixed order that has nothing to do with the order the figures are printed in. An experienced reader wants the shape of the boundary first: what is inside it, how much of the trading never left it, and how much of what is inside belongs to somebody else.

The size of what was cancelled shows how much of a group's trading is with itself, so a practitioner reads a consolidated set backwards from the eliminations. On this group the cancellation of Rs 15,00,000 is 5.1 per cent of consolidated revenue and a much more striking 37.5 per cent of Chitra Binding's own. The 37.5 per cent is the figure that matters, and it is the reason the failure below happens. The routine below, run on this group, takes about four minutes on a real set.

The last row does something the others cannot. The dividend check cannot be done from the consolidated set at all, and it is where a careful reader looks outside that set. Rs 10,00,000 was earned inside Chitra Binding, and Rs 7,00,000 of it belongs to the shareholders of Anjani Stationers by the consolidated arithmetic. No dividend was declared, so not one rupee of it has reached the bank account of Anjani Stationers. A lender assessing the parent alone would care about that a great deal, and a reader looking at the group would not see it at all.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited and the founder, supplier and schools around them are invented.
Educational material. Not advice on any investment, tax, budget or market position.