When one company acquires another company, a consolidated balance sheet needs to be prepared. The first step is to eliminate the effects of any inter-company transactions. There are three basic types of inter-company eliminations. The first type is the elimination of inter-company stock ownership. This entry eliminates both the asset and the stockholders’ equity accounts for the parent company’s ownership of the subsidiary.
The second type of inter-company elimination is the elimination of inter-company debt. When the parent company makes a loan to a subsidiary, the parent company would have a note receivable and the subsidiary a note payable. When the two companies are consolidated, or combined, the loan is just a transfer of cash, so both the note receivable and note payable are eliminated.
The third type of inter-company elimination is the elimination of inter-company revenue and expenses. These inter-company revenues and expenses are eliminated since they are really just transfers of assets from one affiliated company to another and have no effect on consolidated net assets. Some examples of inter-company revenues and expenses are sales to affiliated companies, cost of goods sold as a result of sales to affiliated companies, interest expense or revenue on loans to or from affiliated companies, and rent or other revenue received or paid for services either rendered to or received from affiliated companies.
An important item to understand in regard to consolidated financial statements is the concept of minority interest. A minority interest exists when a parent company owns a majority interest in a subsidiary, but not 100% of the outstanding shares. In this case, the minority interest would be shown on the balance sheet as a type of ownership equity. The minority interest is the ownership interest in the subsidiary that is held by stockholders other than the parent company. Since there are minority stockholders, just the amount of the stockholders’ equity that is owned by the parent company is eliminated.
One of the GAAP guidelines related to consolidated financial statements states that the retained earnings of a subsidiary company that were created before the date of its acquisition can’t be included in the consolidated retained earnings of the parent company and its subsidiaries. In addition, any dividends declared from those retained earnings can’t be included in the parent company’s net income. GAAP also states that comparative financial statements are preferred for annual reports.
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