What Are the Rules of Financial Consolidation?

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Finance and accounting teams don’t just have to close the books. They have to make sure the entire consolidation process is done “by the book” – in other words, that they follow the rules of consolidation exactly as stipulated by regulatory bodies.

In a way, consolidation accounting is like the cardinal rule for organizations that own one or more subsidiaries. If such a company were only to report on its own revenues, for instance, the true nature of its financial performance would be obfuscated. This could deceive investors and auditors who need to understand all sources of income an organization may be generating.

Joining those numbers together to create a consolidated financial statement avoids any confusion in this area. However, the accounting consolidation rules you need to follow may depend on where you’re operating, how much of a stake you have in your subsidiaries, and other factors.

GAAP Consolidation Rules

One of the most common sets of rules in consolidation is based upon the Generally Accepted Accounting Principles (GAAP). You’ll have to determine which of two GAAP models to apply based on the nature of your subsidiary relationships. This includes

A)      The Voting Interest Entity Model: Let’s say your organization is the majority owner of a legal entity like a subsidiary. If it has “absolute power” over key aspects of the legal entity's business and operations, the parent firm will use this model to consolidate its financial data.

B)      The VIE Model: It may look like the same thing at first glance, but this model is only used when the company reporting its financial data has “relative power” over legal entities like a subsidiary. There can also be differences in terms of disclosures that must be provided, how “participating rights” are defined, and even what you mean by having a controlling interest in another entity.

International & IFRS Consolidation Accounting Rules

Now in its 10th version, IFRS stands for the International Financial Reporting Standard, which is set by the International Accounting Standards Board (IASB). Though it shares some of the same rules as those mandated by GAAP, there are some nuances to keep in mind.

Under IFRS, for example, a controlling interest in another entity means the parent firm has power based upon existing rights that can affect investor returns. This could range from the right to appoint key personnel such as a CEO, voting rights, and the details of management contracts.

IFRS focuses on identifying the relationship between the power of a controlling entity and what it means in terms of exposing investors to variable returns.

In the end, IFRS and GAAP are both aimed at ensuring companies properly consolidate financial statements with clarity and transparency.

Rules Informing the Group Consolidation Process

Whether you’re following IFRS or GAAP, make sure you adhere to other common guidelines, such as:

·       Eliminate intercompany transactions: If you’re doing business with your subsidiary – whether selling them goods and services or buying from them – this income can’t be presented in your balances as though you were doing business with an external supplier or customer. You also need to eliminate transactions between two or more of your subsidiaries.

·       Identify any minority interests: Non-controlling interests must be declared, whether they are certain audit rights or participation in sales. Your consolidated balance sheet should list these minority interests in the equities section under GAAP and usually represent between 20% and 50% in terms of equity in an entity.

The Equity Method of Financial Consolidation

Much of the rules we’ve discussed in this post relate to what is known as the consolidation method in accounting. However if the level of equity owned by a corporate parent means it can’t exert much influence over its subsidiaries, it may turn to the equity method instead.

The rules of the equity method mean that when it comes time to report finances, the parent firm will only include its share of a subsidiaries earnings, versus reporting all earnings, expenses, liabilities, and debt that would be common in the consolidation method of accounting. Again, you’ll choose a method and its rules according to whether you own more than half a subsidiary or not.

How Software Helps You Follow the Rules in the Financial Reporting Process

Many firms manage financial consolidation through manual methods when they first start out, especially if they are small. Spreadsheets may seem like a viable option when you’re only producing financial statements that reflect the performance of a parent firm and one subsidiary, for example.

As firms grow, however, making sure you’re doing consolidation by the book may take up more time and effort by accounting teams that are already busy with myriad other responsibilities. The repetitive nature of the tasks involved in consolidating the books, meanwhile, is ideal for automation tools that can execute them in a consistent manner from one reporting period to the next.

The best financial consolidation software solutions are also based on cloud computing, which makes it much easier to keep features current and align with any changes in consolidation rules and guidelines. Letting technology do the job when it might do a better job, in other words, is a good rule of thumb for growing companies to follow.

Marisa Ruffles
Fluence Technologies

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