Question

10. In your own words, describe the purpose of the [ADJ] consolidation entry when the parent company applies the cost method of pre-consolidation bookkeeping.

Answer 1

A consolidation is a summarization of the financial statements of a parent company and those of its subsidiaries. This information is needed by investors and creditors to evaluate the results of an entity and all of its ownership interests.

Consolidation is the process of combining the financial results of several subsidiary companies into the combined financial results of the parent company. This method is typically used when a parent entity owns more than 50% of the shares of another entity.

It can require a considerable amount of time to complete a consolidation, since the reporting entities may use different accounting software, accounting policies, and/or reporting currencies.

1. If the parent uses the equity method of accounting, it recognizes the Equity Income of the subsidiary, less the depreciation and amortization of the [A]AAP net assets, in the Equity Income account on its income statement. In the consolidation process, this Equity Income account is eliminated and replaced with the revenues and expenses to which it relates. Net income is unaffected because we are replacing the subsidiary’s net income (reported in Equity Income) with its revenues and expenses.

2. The parent and the subsidiary it controls are viewed as one entity under GAAP. Therefore, only payments of dividends outside of the controlled group affect consolidated Retained Earnings. Another way of looking at it is this: consolidated Retained Earnings represent the cumulative earnings that are available for dividends to the parent’s stockholders. The payment of cash from the subsidiary to its parent only transfers cash from one company to another. That cash is still available to pay dividends up to the remaining balance in consolidated Retained Earnings.

3. Under the cost method, the parent company, in computation of its pre-consolidation net income, does not include its proportional share of the subsidiary’s net incomeor the AAP amortization. Instead, the parent company, in computation of its pre-consolidation net income, includes its proportional share of the subsidiary’s dividends. Thus, to convert the parent company’s pre-consolidation net income from cost to equity method, the parent company would deduct the dividends received from the subsidiary, add its proportionate share of the subsidiary’s net income and deduct the proportionate share of the AAP amortization. The relation between the resulting parent company equity method pre-consolidation net income and consolidated net income is that they are the same.