Consolidation Method Explained: A Comprehensive Guide

The consolidation method is a type of investment accountingInvestment MethodsThis guide and overview of investment methods outlines they main ways investors try to make money and manage risk in capital markets. An investment is any asset or instrument purchased with the intention of selling it for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends). used for incorporating and reporting the financial results of majority-owned investments. This method can only be used when the investor possesses effective control of the investee or subsidiary, which often, but not always, assumes the investor owns at least 50.1% of the subsidiary shares or voting rights.

 

 

The consolidation method works by reporting the subsidiary’s balances in a combined statement along with the parent company’s balances, hence “consolidated”. Under the consolidation method, a parent company combines its own revenue with 100% of the revenue of the subsidiary.

Learn more about the various types of mergers and amalgamationsAmalgamationIn corporate finance, an amalgamation is the combination of two or more companies into a larger single company. In accounting, it refers to the combination of financial statements..

 

How does the Consolidation Method Work?

The parent company will report the “investment in subsidiary” as an asset, with the subsidiarySubsidiaryA subsidiary (sub) is a business entity or corporation that is fully owned or partially controlled by another company, termed as the parent, or holding, company.  Ownership is determined by the percentage of shares held by the parent company, and that ownership stake must be at least 51%. reporting the equivalent equity owned by the parent as equity on its own accounts. When the companies are consolidated, an elimination entry must be made to eliminate these amounts to ensure there is no overstatement.

The elimination adjustment is made with the intent of offsetting the intercompany transaction and the shareholders’ equity, such that the values are not double-counted at the consolidated level.

 

Consolidation Method Example

Parent Company has recently just begun operation and, thus, has a simple financial structure. Mr. Parent, the sole owner of Parent Company, injects $20M cash into his business. This appears as the following journal entry.

Dr.Cash20,000,000Cr. Shareholder’s Equity20,000,000

 

As such, Parent Company’s balances are now 20M in assets and 20M in equity.

The next month, Parent Company sets up Child Inc, a new subsidiary. Parent Company invests $10M in the company for 100% of its equity. On Parent’s books, this shows up as the following.

Dr.Investments in Subsidiary10,000,000Cr. Cash10,000,000

 

Parent Company now has $10M less cash, but still has a total of $20M in assets.

On Child’s books, the same transaction would show up as follows.

Dr.Cash10,000,000Cr. Shareholder’s Equity10,000,000

 

At the end of the year, Parent Company must create a consolidated statement for itself and Child Inc.  Assuming no other transactions occur in the year, the consolidated statement would look like the following:

 Parent CompanyChild Inc.Elimination AdjustmentConsolidatedAssetsCash10,000,00010,000,00020,000,000Investment in Subsidiary10,000,000-10,000,0000EquityShareholder's Equity20,000,00010,000,000-10,000,00020,000,000

 

As can be seen above, the elimination adjustment is necessary so as not to overstate the consolidated balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting.. If the elimination adjustment were not made, the consolidated assets of both companies would total 30,000,000, which is not true, as money was simply moved between the two companies. In other words, not making the elimination adjustment would result in a false creation of value.

 

Other Accounting Methods

When an investor does not exercise effective controlInvestor InfluenceThe level of investor influence a company holds in an investment transaction determines the method of accounting for said private investment. The accounting for the investment varies with the level of control the investor possesses. of the company it invests in, the investor may possess a minority interest in the company. Depending on the influence this minority interest holds, the investor may either account for the investment using the cost method or the equity method.

The cost method records the investment as an asset and records dividends as income to the investor. The equity method records the investment as an asset, more specifically as an investment in associates or affiliates, and the investor accrues their proportionate share of the investee’s income. This share is known as the “equity pick-up”.

 

Additional Resources

This has been a guide to the consolidation method of accounting for investments.  CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)®Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! designation.

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