Continuing our series on complex system accounting challenges, in this post we discuss the tricky world of consolidation.

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:

Manufacturing
Wholesale Sales $5000
COGS $-2000
Gross Profit $3000

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:

Manufacturing Retail
Wholesale Sales $5000
Retail Sales $3500
Interco. Sales $2500
COGS $-3000
Interco COGS $-2500
Gross Profit $4500 $1000

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:

Manufacturing Wholesale Elimination Consolidated
Wholesale Sales $5000 $5000
Retail Sales $3500 $3500
Interco. Sales $2500 $-2500 0
COGS $-3000 $3000
Interco COGS $-2500 $2500 0
Gross Profit $4500 $1000 0 $5500

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 get tricky. In our next post, we show how things can quickly get complicated.

 

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