Consolidation is a basic accounting concept that’s simple in theory, but complex in the real world. In this post, we’ll cover the basics of consolidation, some of the challenges that emerge and possible solutions.
In the context of financial accounting, consolidation is the aggregation of the financial statements of two or more companies under the same ownership into a consolidated financial statement. To really grasp consolidation, you need to understand that in the outside world, no one cares about money that’s traded back and forth between different companies under the same ownership. In the outside world, the only revenue that counts is revenue coming from a real customer. That’s what consolidation is all about – putting together financial statements that eliminate all the internal back and forth and focus only on “real” customer revenue.
Let’s explain how this works with an example of a growing company.
ACME makes and sells widgets to wholesalers around the country. Focusing on the income statement, let’s say (for absolute simplicity) that ACME sells 1000 widgets at a price of $5.00 each and a cost of $2.00 each. Its income statement would look like this:
Everyone’s happy. The company makes money. And any system can handle the accounting.
As ACME grows, it decides to open retail stores. And these retail stores are set up as a different legal entity. This creates more complexity because the manufacturing entity must “sell” widgets to the new retail entity. Let’s assume ACME sells 1000 widgets to its wholesale customers and another 500 widgets through its retail channel. Let’s also assume that the manufacturer charges the retail division the same price it charges outside customers. The retailer then charges its customer $7.00 per widget for a total of $3500. We now we have two income statements, one for manufacturing and one for wholesale:
Now it’s time to consolidate the income statements. If we add all revenue together, we’d have a total of $11,000. That’s not right. We only sold 1500 widgets and the total price out the door was $8500. So, we have to make journal entries to “eliminate” the intercompany entries while preserving the original statements for the manufacturing and retail group. Elimination simply means backing out all intercompany activity transactions.
So, we set up an additional “elimination statement” either through Excel, by creating a dummy company in the accounting system, or with special consolidation software. Our numbers now look something like this:
Thus far we’ve dealt only with the income statement, but the same logic applies to balance sheets.
A few additional things to note:
We recommend keeping separate accounts for intercompany and external company transactions. This makes elimination easy. Too often, intercompany and external transactions are mixed together, either because systems are inadequate or not set up appropriately.
As a concept, consolidations aren’t that hard. And in many companies, even mid-size ones, no one pays much attention to them. Often, outside accountants create the consolidated financial statement and only the CFO Controller and/or the bank looks at it. Often, business leaders look only at their individual statements to go about their business.
Yet, in practice, consolidation can quickly get complicated.
How Consolidation Gets Complex
At the end of the day, consolidation is really about addition – adding in balancing entries. But things can get complicated quickly. Here are some of the complexities we see regularly:
1. Scaling Up to Multiple Systems
On purpose, we’ve used a simplified example. In reality, it’s rare to have such a simple situation. As companies grow, structures get complex, and multiple levels of consolidation must occur. While some people stick with an Excel solution as long as possible, it just isn’t trustworthy. Often, when people “upgrade” from Excel to a real system, they discover that what they thought was working, wasn’t.
2. Setting Up Intercompany Costs
In our example, widgets were sold at the same price to outside wholesalers and the company-owned retailer. But life is rarely so simple. There are all kinds of reasons management may want different intercompany prices. Some we’ve heard include:
- The effort it takes to sell to a related company is much less then the effort it takes to sell to an outside party. The price should reflect that.
- We can’t let those guys know our costs. If the sales guys in division X knew the cost, they’d undercut our prices.
- Everyone here gets paid based on margin. We have to set reasonable margins around the organization to keep compensation in check.
If you’re operating within one country, you have a fair amount of leverage (with some restrictions – talk to your tax guys) on allocating your profit. When your entities are in different countries, things get more complicated. Every government in the world wants to collect more tax. Any costs you set between companies need to be justified. If your manufacturing plant in Mexico charges too little to the U.S., the Mexican government is going to want to know why.
In these situations, you often need to maintain two sets of books – one for tax and one for management.
3. Currency Issues
Currency issues (the subject of an upcoming post in this series) are complex even when you aren’t consolidating. When you are consolidating, they’re even worse. If manufacturing sells to retail, what currency do you use for that transaction? How do you track the value over time? This topic deserves its own post. Stay tuned.
4. How Much Money Do Your Divisions Make?
Companies go through consolidation because outsiders don’t care about all your inter-company back and forth. They only care about the net revenue you earn from customers, not coworkers.
While simple eliminations can create a consolidated view, they don’t help you determine how much money each division really made. To figure that out, it’s not enough to eliminate entries, you also need to allocate costs. Let’s demonstrate with our earlier example:
We assumed a $2.00 cost per widget. Manufacturing charged the retail division $5.00 per widget. Is this fair? Should manufacturing get all the credit? Or should it be split differently? Which divisions should assume which portion of the costs?
5. Partial Ownership and Joint Ventures
So far in our examples, we’ve pretended that all our companies are owned fully by the same entity. This isn’t always the case. How do you consolidate with partial ownership or complex joint ventures?
Let’s take a look at handling these complexities.
Solving Consolidation Challenges
If you’ve been following our blog for awhile, you probably know we believe in implementing the simplest solution possible to get the job done. We apply this approach to consolidation as well. We’ve identified four different ways to solve consolidation challenges.
1. Outside Accountants
For mid-sized companies with two or three entities, the most common approach is to let outside accountants deal with it. When a company has to answer to its bank and a few owners, a consolidated statement is generally not all that important – it’s something they have to produce once a year at most. And while auditors who follow strict rules of independence shouldn’t be doing your consolidation for you, smaller accounting firms generally handle such things in the normal course of business.
When all else fails, use Excel – the accountant’s Swiss Army knife. Again, this can work to a degree. If you only have a few entities and don’t have to consolidate statements very often, then Excel is fine. Generally companies start using Excel when their outside accountants stop doing consolidations for them, and consolidation remains an occasional chore rather than a key part of the financial close.
3. The General Ledger
Any General Ledger that can support a mid-sized company will have the ability to create multiple legal entities. We often use this ability to get elimination entries into systems and out of spreadsheets. Database driven ledgers are preferable to spreadsheets because they are far better at ensuring data consistency.
Even if all your companies don’t use the same GL system, you can still make it work by writing an interface between ledgers. We’ve done this for many clients because it’s generally easier (and more cost effective) than buying new software just for consolidation
4. Multiple Sets of Book Within One System
As we mentioned in our example, sometimes you need to keep multiple sets of books – one for management purposes and one for tax purposes. You might even need a third set for GAP purposes.
While you can use your standard ledger to get most of the way there, you might want to find out if your system has the ability to have multiple ledgers within one system. While you still won’t be generating your consolidation automatically, you’ll at least meet management and statutory needs with one system.
5. Real Consolidation Software
When you grow beyond a certain size, your ledger (even if it can support multiple sets of books) isn’t enough. That’s when it’s time to check out software designed to handle consolidations. Some examples are SAP Planning and Consolidation or BPC or Oracle Hyperion Financial Management software.
One final cautionary note: Software isn’t a panacea. A great team can get the job done with just okay software, while perfect software won’t save a mediocre team. To get the desired results, you really need to nail down the non-software side. Different divisions have to talk to one another. They need to agree how they’re going to make entries and do it in a timely manner. They need to agree to a close schedule so month end doesn’t turn into a mad house with people scrambling to find matching entries. They need to use their systems to the fullest, so it’s easy to segregate internal and external company transactions.
If you have these kinds of processes in place, then your software will do the job. If not, gold plated software won’t be enough.