Purpose and Function

The consolidated balance sheet is a form of statement distinctively American. As indicated in previous chapters, its use has arisen as a result of the corporation laws of some of the states which allow the formation of the holding company. This, if strictly a financing company, has a very simple operating organization. Its chief assets are usually the securities, capital stock and bonds, of the subsidiary companies which it owns in part or in full. Accordingly, its balance sheet is comparatively simple; in fact this very simplicity results in giving little information as to its real financial condition or that of the subsidiaries which it owns. If, however, the holding company is at the same time both an operating and a financing corporation, all the complexities encountered in the balance sheet of a manufacturing company will be found on that of the holding company. However, the financial statement of an operating holding company is not any more intelligible because of its complexity than that of a purely financing corporation.

The items on the balance sheet of either type of corporation which are evidence of the activities peculiar to a holding company are, as stated above, the securities of the subsidiary concerns held by the holding company and whatever advances have been made on open account to the various subsidiaries in order to provide funds for making extensions or for recouping losses incurred by the subsidiaries. The principles governing the valuation of the securities of the holding company have already been stated and explained in Chapter XV. In that chapter were stated the different applications of the principles of valuation to the three conditions met; namely, (1) the condition in which the holding company owns the entire capital stock of the subsidiary; (2) the condition in which a controlling but partial interest only is held; and (3) the condition in which the holding company is a minority stockholder of the subsidiary. In making up the balance sheet of the holding company the application of these principles to the valuation of the holdings of the corporation must be carefully handled. Aside from this problem of valuation, the balance sheet of the holding company presents no new problems. Such a balance sheet, however, gives very little information as to the actual financial condition of the corporation because its finances are tied up so completely with the financial condition of the various subsidiaries. In order, therefore, to present a statement which will intelligently show the real condition of the holding company, it becomes necessary to combine or consolidate the statements of financial condition of all its subsidiaries.

Problem of Partial Ownership

Where the ownership of the subsidiaries is complete, the consolidated balance sheet in which are brought together all the various assets and liabilities of the subsidiaries, presents a true, full, and intelligent statement of the financial condition of the holding company. Where, however, ownership is not complete, in which case there may be majority or minority holdings, the problem of drawing up a statement which will present the actual condition of the holding company is more difficult and much more complex. Manifestly, a consolidated balance sheet under either of these latter conditions as to partial ownership cannot be applicable alone to the holding company, inasmuch as in such a statement there must be included interests over which the holding company has no direct control or authority.

Because of this difficulty, three different ways of attempting to show the holding company’s condition are met with. One method makes no attempt to overcome the difficulty but limits itself to showing simply the balance sheet of the holding company as explained in the early part of this chapter. A second method consists in showing the balance sheet of the holding company supported by the separate balance sheets of all of the subsidiary companies. The third method is the method of the consolidated balance sheet which has just been briefly explained. This last is, perhaps, the most satisfactory method of the three. The insufficiency of the first method and the objection to it have been referred to already. The second method gives all essential information but presents it in such form that it is practically impossible for anyone but a trained student of finance and accounting to correlate the various parts and arrive at an intelligent understanding of actual conditions. The stockholder or the outsider is usually completely at a loss to know the meaning of all the figures and statements presented. Under the third method the data as to the condition of the various companies are brought together and presented in logical form on the consolidated balance sheet so that the combined statement shows as clearly as is possible the condition of the holding company.

Conditions under which Used

It should be clearly understood that the consolidated balance sheet is not a balance sheet of the holding company except and only when the holding company owns the entire capital stock of all the subsidiaries. A consolidated balance sheet, therefore, is a statement which presents the condition of all of the subsidiary companies. If it reflects the condition of the holding company better than the latter’s balance sheet, then, and then only, should a consolidated balance sheet be used. A fine distinction must sometimes be drawn to determine when it is more desirable, in the interests of an accurate showing of condition, to present a consolidated balance sheet rather than the balance sheet of the holding company, and a delicate appreciation is needed of the various financial problems involved. When the holding company is not the complete owner but nevertheless has a controlling interest in all the subsidiaries, the method of the consolidated balance sheet is usually the better way of showing its financial condition. Where the holding company, however, holds only minority interests, it is oftentimes open to question as to whether the consolidated balance sheet gives a true presentation of the facts of financial condition, especially in view of the fact that the holding company cannot always control the policies of its subsidiaries.

The Setting Up of the Consolidated Balance Sheet

With this explanation of purpose and function of the consolidated balance sheet, it is purposed now to draw attention to some of the problems met in drawing up such a statement. The first essential condition to facilitate the consolidation of the balance sheets of the various subsidiaries with that of the holding company is that standardized methods of accounting resulting in a similar classification of accounts and presentation of results be used by all the subsidiaries. The consolidated statement is then merely a combination of the values of similar items in all the balance sheets to determine the valuation at which the consolidated items shall appear.

On the balance sheets of the various companies certain accounts will appear which represent intercompany relationships. Thus, on that of the holding company appear the securities which are represented on the statements of the subsidiaries by their net assets. In other words, the securities of the holding company are assets represented by the proprietorship items of the various subsidiaries. Sometimes on the consolidated balance sheet both items are shown. This results, of course, in an almost exact duplication of items inasmuch as the holding company’s securities are a statement of the net asset values of the subsidiaries. The better method of presentation, however, seems to be the elimination of the securities of the holding company against the proprietorship items of the subsidiaries. It may frequently happen that the values of these two items to be eliminated are not the same. This will always be the case if the holding company values its securities either above or below the par of the capital stocks of the subsidiaries, plus any surplus belonging to the subsidiary at date of purchase by the holding company.

It is to be presumed that the values at which the securities are held on the books of the holding company represent the latter’s estimate of the value of its interests in the various subsidiaries. If this value is more than the net worth of the subsidiary as shown by its capital stock outstanding and surplus at the time of purchase by the holding company, the difference between the value at which the securities are carried by the holding company and the net worth of the subsidiary must represent the value placed by the holding company on the good-will of the subsidiary. This good-will does not appear, of course, on the books of the subsidiary. Hence, in consolidating the balance sheet of the subsidiary with that of the holding company, it is necessary to set up the asset good-will and thus increase the net worth of the subsidiary to the point where it can be exactly canceled against the value of the securities on the balance sheet of the holding company. If, however, the value of the securities on the holding company’s books is less than the net worth of the subsidiary, that condition indicates that in the opinion of the holding company the assets of the subsidiary as carried on the subsidiary’s books are overvalued. In this case it becomes necessary, upon consolidation, to set up a depreciation reserve under suitable title.

The effect of this, so far as the eliminations on the consolidated balance sheet are concerned, is merely to set up under the title Depreciation Reserve the portion of the subsidiary’s capital stock—or capital stock and surplus—not canceled by the amount at which the holding company carries on its books the value of its interest in the subsidiary. Instead of carrying this difference in values under the title Depreciation Reserve, it is sometimes shown as Capital Surplus. This is merely another way of saying that the portion of the subsidiary’s capital stock not canceled by the holding company’s investment in the subsidiary is simply carried on the consolidated balance sheet under another name. Another method of handling this uncanceled amount is to carry it into the consolidated balance sheet as a credit to Good-Will account, and so secure a reduction in the value at which this intangible asset is shown in the balance sheet of the allied companies. This may sometimes result in reducing the value of good-will to a negligible figure, or in writing it off the books entirely, or even in showing it with a credit balance. There is little to choose between the methods; the author prefers the use of the depreciation reserve. The balance sheets of all of the subsidiaries are in this way consolidated with the balance sheet of the holding company.

On the consolidated balance sheet as at the date of the purchase of the various subsidiaries, there will not therefore be shown any item of surplus, inasmuch as the items of surplus on the balance sheets of the various subsidiaries have been eliminated together with their capital stock items against the securities on the balance sheet of the holding company. This is as it should be. Surplus account properly used should represent only profits reserved from operation. The holding company cannot, therefore, previous to its operation, show any item of surplus even though the subsidiary companies have accumulated profits which they, of course, are entirely right in showing under the title Surplus.

A distinction must be made here between what is termed “contributed” surplus and “operating” surplus. Any corporation, the holding company included, may at the time of its organization have some portion of its capital represented by contributed or capital surplus. It has been pointed out that this may arise either through subscription to its stock at a premium, or by a later donation of stock by its stockholders which, when sold, may be recorded as working capital surplus or contributed surplus. It is not possible, however, for any corporation, previous to its operation, to show as a balance sheet item an operating surplus from which it might be possible to declare dividends.

Showing of Intercompany Accounts

At the time of consolidation, intercompany accounts of various sorts will also appear. The holding company may have made advances of cash to some of the subsidiaries. These will be shown on the books of the holding company as open account claims against the subsidiaries, while on the books of the subsidiaries they appear as increases among the assets—usually cash or other current items—offset by open liability claims in favor of the holding company. The account receivable on the holding company’s books should be eliminated against the account payable on the books of the subsidiary. Similarly, there may be numerous inter-subsidiary accounts which may be eliminated, the ones against the others. The need for a very careful classification of accounts receivable in order to separate the claims against trade debtors from those against allied companies should be emphasized when it is desirable to consolidate balance sheets on which these various classes of accounts receivable appear.

Showing of Notes Discounted

One kind of intercompany item needs further consideration. A corporation may, as the holder of the notes of an allied company, have had those notes discounted. On the maker’s books the notes appear as a liability. On the holder’s books, after discount, the notes will be shown as a contingent asset offset by a contingent liability of equal amount. Upon consolidation of all the balance sheets, neither the contingent asset nor liability will appear, being canceled against each other, but the full liability as maker of the notes must be shown; for now that the notes have passed into possession of an outsider, the bank, the liability is no longer an intercompany liability but one for which the consolidated interests are fully liable.

Reconcilement of Current Accounts

Previous to the consolidation of the balance sheets, it is possible that some of the intercompany accounts may need reconciliation just as any other current accounts. For instance, Company A may have shipped goods to Company B and have charged B’s account, but A’s account on B’s records may not yet have been credited because the goods have not yet been received. All items in transit will require reconciliation. These are all intercompany transactions which will be eliminated upon consolidation; but to make exact cancellation possible, the intercompany current accounts on the books of the various companies must be reconciled.

Valuation of Inventory

The problem of the valuation of the stock-in-trade inventory on the consolidated balance sheet is perhaps the most troublesome. The situation with regard to inventories of stock-in-trade is often complicated by the fact that the same raw material or partly finished material may pass through the hands of several companies each doing certain processes upon it. The process of manufacture may not be completed until the goods are turned over ultimately to the holding company for sale and final distribution to the consumer. This—or other possible variations of the procedure—is usually the situation so far as stock-in-trade is concerned. Inasmuch as the various subsidiaries are independent corporate organizations, the price at which they transfer their product to the allied subsidiaries is not cost price but a sale price determined, perhaps not by market conditions, but rather by some fixed policy set by the holding company; although it frequently happens that market price is the price at which the partially completed product is turned over to allied subsidiaries. However determined, the price includes an element of profit which from the standpoint of the holding company is not a realized profit until the goods are finally disposed of to the outside consumer. Were the manufacture carried out by a single corporate organization, the product, as it passed through its various stages of manufacture, would be charged into each succeeding stage at the costs accumulated during preceding stages, and the element of profit would not need to be considered until the product was ultimately sold by the holding company.

Thus, the valuation at which the inventory of stock-in-trade is carried on the books of the various subsidiaries is often inflated by the profit in each case, so that by the time the product reaches the holding company it may carry a very large element of unrealized profit. While from the standpoint of each subsidiary company the act of transfer has been legally a sale and therefore the seller is entitled to a profit on the sale, without which there would be no element of profit appearing in the operations of each subsidiary company at any time, from the standpoint of the holding company such transactions are in no sense sales, but are simple transfers from one process or stage of manufacture to another.

In order to show the true condition as to the value of the inventory of stock-in-trade on the consolidated balance sheet, it becomes necessary to eliminate these intercompany items of profit loaded onto the goods at the time of transfer between companies. The figure at which the value of the consolidated inventories will appear in the consolidated balance sheet should represent the actual cost figure, as if the entire process of manufacture were carried on under one corporate organization. The corresponding offset to this reduction in value of the consolidated inventories will appear as a reduction in the surplus as shown on the consolidated balance sheet.

This principle of inventory valuation should always be applied to the full in the case where the holding company is the complete owner of all its subsidiaries. It cannot, however, be too rigorously lived up to under conditions where the holding company may not have absolute control over the policies of the subsidiary companies. It may sometimes even be modified by the fact that the product as turned over by one company to another is in such stage of completion that there is a ready market for it outside that of the allied subsidiaries. The accountant is, however, treading on somewhat uncertain ground when he attempts to incorporate any element of profit in the consolidated inventory. Conservative management as adopted by some of our largest corporations eliminates all elements of profit, and that should be the standard practice. Only under unusual circumstances and after a very careful consideration of all the conditions should the consolidated inventory be carried at any other valuation than that of full manufacturing cost.

Reserve for Intercompany Profits

In eliminating intercompany profits from the valuation of the inventory, use is sometimes made of a Reserve for Intercompany Profits account. The reserve is created by a charge against Surplus. The inflated valuation of the inventory is allowed to stand but it is offset by this reserve in sufficient amount to reduce its value to a cost basis.

Valuation of Inventory—Minority Interests

An interesting problem arises in handling the consolidated inventories and other similar items when there are minority interests to be taken into account. To write down the inventory to a cost basis for the consolidated companies involves a valuation below cost for the subsidiary companies which purchased the commodities from their allied companies. This is hardly equitable to the minority interests in those companies, for they are concerned not with what is the proper basis for valuation on the consolidated balance sheet but rather on their own balance sheet. Their company as a distinct legal organization has the right to show all the profits arising out of a valuation of its inventory on its own purchase-cost basis. Recognizing this right, some accountants advocate carrying the portion of the inventory represented by the ratio of the minority interests to the whole interests, at the cost price to the subsidiary and writing down the rest of it to a true cost basis for the consolidated companies. The effect of this is to leave undisturbed the portion of the subsidiary’s surplus belonging to, or, more strictly, representing the minority interests. Such a method results in the valuation of the inventory on two different bases for the consolidated balance sheet—a practice which is objectionable. The more conservative policy is to write down the whole inventory to a consolidated cost basis, charging the amount written off against the consolidated company’s surplus. This will leave the minority interest surplus unaffected by the changed basis of valuation—a desirable thing from the standpoint of equity to the minority.

Valuation of Liabilities

So far as the liabilities of the corporation are concerned, the values at which these will be carried on the consolidated balance sheet will be the combined values of all the liabilities of the subsidiaries, aside from the intercompany accounts payable and other similar items which have been canceled against the accounts receivable of the subsidiaries and holding company.

Showing of Capital Stock

The showing of the capital stock item on the consolidated balance sheet will depend somewhat on the degree of ownership of the holding company. If the ownership is partial, in addition to the capital stock of the holding company a statement must appear of the consolidated minority interests of the various subsidiaries. This should, of course, be shown separately from the capital stock of the holding company. This becomes necessary because of the fact that items which do not belong in full to the holding company have been incorporated with the assets on the consolidated balance sheet. It is seldom if ever feasible to attempt a separation of the various asset items on the basis of the degree of ownership of the holding company; hence, the only offset to the inclusion of asset values not belonging to the holding company is by showing the outside interest in those assets by means of the minority holdings of capital stock.

Showing of Surplus

The other element of net worth, i.e., the surplus, will also have to be adjusted in order to give the best showing of the interest of the various parties therein. This is, of course, the operating surplus referred to above. The portion of the surplus belonging to the holding company as indicated by its proportion of ownership in the allied companies will be shown separately from the portion of surplus belonging to the minority interests. Sometimes when this is relatively insignificant it is shown as a liability rather than as an item of net worth, on the ground that the minority has a claim on that surplus and will very probably, in the near future, receive it by way of dividends. It would seem to be, however, a truer index of the exact status of affairs at the time of the consolidation, to show the item separately as a portion of surplus in the net worth section of the balance sheet.

Showing of Deficit

When it becomes necessary to incorporate a deficit rather than a surplus, conservative practice usually demands that the entire deficit be shown as belonging to the holding company rather than merely its proportionate share as indicated by its share of ownership in the subsidiary. This is advisable because an initial deficit is often an indication of the inability of the company to be operated profitably, in which case the holding company may have to stand practically the entire deficit.

Showing of Profit and Loss Summary

The consolidated balance sheet should be supported by a consolidated profit and loss summary. Just as with the balance sheet, a distinction is made between the profit and loss statement of the holding company and the consolidated profit and loss statement in which are brought together the summaries of all of the allied companies. If the holding company is primarily a financing company, its chief source of earnings will be from dividends on the stocks of the subsidiary companies held by it. The profit and loss summary of the holding company may be a true reflection of its earning condition for the current year if proper provision has been made for the losses of the subsidiary companies which have been operated unprofitably. The information which the holding company’s profit and loss summary gives, however, is not adequate or sufficient on which to base an intelligent judgment as to whether it is a correct statement of current operations. Much the same difficulties are met in connection with it as in connection with the balance sheet of the holding company referred to above. For instance, if, during a given period, some of the subsidiary companies were operated at a loss or on a narrow margin of profit but dividends were declared out of surplus earnings accumulated from other periods, there would be no indication on the profit and loss summary of the holding company as to the actual conditions under which the earnings of the holding company had been secured. In other words, there would appear on the profit and loss summary of the holding company as earnings for the current period items representing accumulated earnings from previous periods.

Thus, the profit and loss summary of the holding company would not give a true reflection of the earnings for the current period, and furthermore would give no information whereby it would be possible for an interested party to form any judgment as to the current operations of the holding company and its subsidiaries. Inasmuch as the holding company usually owns a majority interest in all the subsidiaries and therefore can dictate their policies, the management of the holding company is always in possession of the true status of affairs, but the stockholder or other interested party can form no judgment whatever as to the actual condition. On the profit and loss statement of the holding company there will be no data as to gross earnings, operating expenses, fixed charges, or miscellaneous income and expense items reflecting the operating conditions of the various subsidiaries. Furthermore, if a subsidiary company has been operating at a loss and has declared no dividend, the absence of that item of earnings from the profit and loss summary of the holding company would not be necessarily a proper reflection of the condition of the subsidiary on the holding company’s summary. It might be necessary, in order properly to show the true condition of affairs, to make provision by way of a reserve for the loss of the subsidiary.

Again, it becomes very easy, if control of the holding company is in the hands of an unscrupulous clique, to understate the profits of the holding company by refusal to declare such a dividend on the part of each subsidiary as will reflect the true earnings of the subsidiary for the current period. Such a policy may be used for the purpose of manipulating the stocks of the various companies.

The Consolidated Profit and Loss Summary

For these reasons and others of the same kind as those mentioned in connection with the balance sheet of the holding company, it is best, in order to give an intelligent showing of condition, to set up a consolidated profit and loss account. The comment made on the consolidated balance sheet is here pertinent also. It is not a profit and loss account of the holding company for it includes also items representing other interests. In some respects it is an unwieldy instrument, but it seems to be the best way in which to show the actual condition of the holding company’s operations. On the consolidated profit and loss summary the earnings from dividends which appear as the chief source of the holding company’s earnings on its profit and loss summary will be eliminated and in their stead will appear the combined earnings of the allied companies. This might seem to be an inflation of earnings inasmuch as the goods which were sold by one company and are recorded by it as earnings will be resold by another company on whose books they will appear also as earnings. The sale of the same goods may thus appear as earnings in many of the subsidiaries. However, such a showing of combined results does provide a true basis on which to judge earnings in comparison with the values invested by the various companies from the use of which values the earnings have been derived. Similarly, on the consolidated profit and loss statement will appear all the operating expenses and other items belonging to the individual profit and loss summaries of the subsidiaries. As it is necessary on the consolidated balance sheet to make some adjustments in the surplus on account of the unrealized elements of profits in the values at which the combined inventories were taken over, so this same adjustment will perhaps be best handled as an appropriation of profits in the last section of the consolidated profit and loss summary.

If the holding company owns all of the stock of the subsidiaries, a true profit and loss summary with no inflated values should be drawn up. In this there will appear only the sales to outside consumers; no intercompany sales should be shown. The cost of goods sold will be determined on the same basis, viz., the basis of cost from the standpoint of the consolidated companies as a unit organization, all intercompany profits being eliminated. All the expenses of the subsidiaries are loaded onto, and therefore absorbed in, the cost of the goods sold by the holding company. Usually only the holding company’s expenses—selling, general administrative, etc.—will appear as such on the consolidated profit and loss summary. Where, however, there are minority interests to be taken into account, the method of combining all the elements is doubtless the most satisfactory.

Illustration of Consolidated Balance Sheet

Problem. Company X, the holding company, owns all of the capital stock of Company Z and 60% of the stock of Company Y. Company X is chiefly the financing company, Company Y is the selling company, while Company Z manufactures the commodities and turns them over to Company Y at a price slightly under the market. The following balance sheets of the several companies show their condition at the close of the fiscal period. Company Z records show that the cost of the merchandise carried on the balance sheet of Company Y at $75,000 is $60,000. It is required to draw up a consolidated balance sheet of the affiliated companies.

Solution

Comments on Problem. There is little in the solution to which attention need be directed. In the handling of the capital stock items, it will be noted that only $300,000 of Company Y’s stock is eliminated, the remainder of $200,000 being shown on the consolidated balance sheet as a minority interest. In eliminating Company Z’s capital stock, it becomes necessary to bring a good-will item of $100,000 onto the consolidated balance sheet. This is shown on the working sheet by means of the three “f” items in the “Elimination” column. On the consolidated balance sheet it will be noted that the minority interest in Surplus (40% of $25,000, Y’s surplus) is not shown affected by the reduction of Y’s inventory to a cost basis. The solution assumes that all the surplus items on the balance sheets of the various companies represent operating surplus accumulated since the purchase of the subsidiaries by the holding company.

This problem calls attention to some of the questions encountered in handling the consolidated balance sheet, although in practice much more complicated situations arise. All that can be hoped for here is to impress upon the student some fundamental principles to be observed and to point out some of the methods used in order best to express the relations of the various interests in the business. The idea of the consolidated balance sheet is simple in concept but usually difficult of full realization.