What are the different consolidation methods? Pros, cons, and examples

Financial consolidation is essential for getting an accurate view of an organization’s financial health.

Whether it has multiple subsidiaries, investments, or just a complex management structure, consolidation is essential to identify and solve cash flow problems, over-leveraging, significant tax burdens and more.

In this article, we’ll outline how this process works, including:

What is financial consolidation?

Financial consolidation is a process used by companies to combine their financial statements with those of their subsidiaries. This is done whether the parent company owns a majority share—50% or more—of the subsidiary or not.

The goal of financial consolidation is to accurately represent each company’s assets and liabilities and reconciling what would otherwise be duplicate transactions—such as an investment from a parent company into a subsidiary.

How often do companies do financial consolidation?

A company typically decides whether to consolidate its financial statements on a yearly basis. That decision usually comes down to tax advantages; in some cases, consolidated statements can lead to significant savings. While a private company can simply choose to consolidate financial statements come their year-end close, a public company may need to file a request to make this change with the appropriate regulatory body.

What is a financial consolidation method?

There are multiple ways companies can consolidate financial statements. The method used depends largely on how much of the subsidiary is owned by the parent company and how much control the parent has over operations. The three financial consolidation methods are:

• Full consolidation (VOE and VIE model)
• Equity method
• Proportionate consolidation

Method 1: Full consolidation (VOE model)

With the full consolidation method, all a subsidiary’s assets, liabilities, and revenues are consolidated with the parent company’s financial statements. The Voting Interest Entity (VOE) model is one type of full consolidation, used when a parent company’s ownership of a subsidiary is determined with voting interests.

When to use

To use the VOE model of the full consolidation method, one of the following criteria must be true:

• Ownership of a majority voting interest (usually more than 50% of voting shares).
• This means the parent can appoint or remove board members, exercise significant influence over the subsidiary, or directly control activities that impact the subsidiary’s returns.

Essentially, this version of the full consolidation method is only available when the partner company controls significant financial and operational decisions within the subsidiary (known as participating rights). Note that, in certain cases, the ownership of specific participating rights by a non-controlling shareholder may mean that full consolidation isn’t possible.

In addition, the subsidiary must not have one of the five characteristics of a variable interest entity (VIE). Similarly, the subsidiary or parent company may need to qualify for an exemption from the VIE model-more on that later.

How to use

Full consolidation is the simplest consolidation method since all a subsidiary’s assets, liabilities, and equity are reported by the parent company. Revenues and expenses are also consolidated with the parent’s financial statements in full. Most of the work done in this method of consolidation will involve gathering financial information from subsidiaries rather than doing any sort of complex accounting.

Pros

The VOE model of the full consolidation method has the following advantages:

• Accurately reflects control: With full consolidation, financial statements accurately represent the parent’s company controlling interests in subsidiaries, as opposed to unconsolidated statements.
• Eliminates duplicate transactions: If, for instance, a subsidiary sells goods to a parent company, consolidation will eliminate the relevant transactions. This gives a more accurate picture of each entity’s financials.
• Better transparency for shareholders: For private companies, consolidated financial statements allow shareholders to get a better view of a parent company’s relevant holdings. Public companies may be required to consolidate their statements.
• Tax advantages: By consolidating statements with owned subsidiaries, parent companies can offset losses in one entity against the profits of another.

Challenges

While it has its benefits, this model of full consolidation also comes with some challenges:

• It’s time-consuming: Gathering all the financial information you need for a full consolidation can take quite some time.
• It isn’t as precise: Other methods of consolidation may provide additional details that a full consolidation glosses over since it rolls up all a subsidiary’s financials into the parent company’s statements. Subsidiaries with lower performance, for instance, may have this problem obscured when consolidated with a high-performing subsidiary.
• Intercompany transactions complicate things: If parent companies and their subsidiaries are often buying and selling goods and services between themselves, the team managing the consolidation will have to go through and eliminate these transactions.

Full consolidation (VOE Model) Example

Here’s a step-by-step example of how a parent company, Company X, would use the VOE model of full consolidation with subsidiaries Company A, Company B, and Company C.

Step 1: Identifying entities to be consolidated

First, Company X would need to identify which entities need to be consolidated. To keep things simple, let’s just look at the stake it owns in each subsidiary.

Company A: 51%

Company B: 35%

Company C: 65%

Company D: 15%

After review, Company B and Company D can’t be added to a fully consolidated financial statement since Company X doesn’t own a majority of voting shares in either.

Step 2: Eliminating intercompany transactions

Now that Company X needs to include Companies A and C in its full consolidation, its finance team must identify intercompany transactions between the parent company and its subsidiaries. They might find that subsidiaries have been buying and selling products between themselves, or that Company X has paid a consultant from Company A to help revamp some of its processes. Here are the amounts that qualify as intercompany transactions for each entity:

Company X: $400,000 in expenses, meaning the new total expenses are $9,600,000.

Company A: $200,000 in income, meaning the new total income is $800,000.

Company C: $200,000 in income, meaning the new total income is $250,000.

These will be reflected in the final consolidated statement.

Step 3: Combining assets, liabilities, equity, income, and expenses

After eliminating intercompany transactions, the finance team can now create a consolidated financial statement for Company X. By adding up income, assets, liabilities, equity, and expenses from all subsidiaries to the parent company’s own balance sheet, the finance team gets this result.

Method 2: Full consolidation (VIE model)

The actual consolidation part of the variable interest entity (VIE) model works essentially the same way as the VOE model; a parent company consolidates the full value of a subsidiary’s assets, liabilities, equity, income, and expenses. The main difference is in how the parent company determines which entities it can consolidate.

When to use

To determine when an organization should use the VIE model of full consolidation instead of the VOE model, the Office of the CFO needs to evaluate their stake in the entity, the kinds of rights they have, and whether the entity is subject to exceptions that would make the VOE model more appropriate. This flowchart from Deloitte details this process succinctly.

How to use

Since the consolidation aspect of this model is the same as with the VOE model, the consolidating organization would follow the same steps:

1. Identify the entities to be consolidated.
2. Eliminate intercompany transactions.
3. Combine assets, liabilities, equity, income, and expenses.

Pros

When compared to the VOE model, the VIE model has some advantages:

• Easy to identify VIE subsidiaries: While in a perfect world, a parent company would only have to show it owns a majority of a company’s shares to consolidate it under the VOE model, things are rarely that simple. With the VIE model, it’s easier to identify controlling stakes and determine which companies should be consolidated.

• More frequently results in consolidation: Since it’s usually easier to satisfy the requirements of the VIE model than the VOE model, more activities can be used to show that a parent company should consolidate a subsidiary.

• Simplest consolidation: All assets, liabilities, equity, income, and expenses are added to the parent company’s financial statements, which is simpler than other consolidation methods.

Challenges

Here are some challenges that come with this model, as compared to using the VOE model of full consolidation:

• Complex compliance requirements: While proving the need for consolidation is easier with the VIE model, there are more requirements and exceptions to navigate to do so.

• Information overload: The amount of financial information that needs to be gathered for consolidation can be staggering, leading to a time-consuming process.

• More activities to evaluate: Since there are more elements that go into establishing ownership with the VIE model, your teams will need time to evaluate them all.

Example

Let’s dive into a step-by-step example of how a parent company, Company X, might use the VIE model of full consolidation with Company A, Company B, Company C, and Company D.

Step 1: Identifying identities to be consolidated

Before consolidating assets, Company X needs to determine which companies it can consolidate assets from. While the finance team at Company X already knows they can consolidate Company A and Company C because the organization owns a majority stake in them both, there are some additional considerations to apply to Company B and D.

While Company X doesn’t own a majority stake in Company B, it does have the power to direct activities that have the most impact on its revenue, maybe through influence on the board or a close relationship with some important departments. Additionally, under a contract with Company B, Company X must absorb losses and can receive benefits from the entity’s financial activities. Under the VIE model, that would mean Company B can be consolidated.

None of this is true for Company D, so it is excluded from consolidation.

Step 2: Eliminating intercompany transactions

Before consolidating Company A, Company B, and Company C, the finance team at Company X needs to examine ledgers and financial statements to identify and exclude intercompany transactions. Here’s what they discover:

Company X: $500,000 in expenses, meaning the new total expenses are $9,500,000.

Company A: $200,000 in income, meaning the new total income is $800,000.

Company B: $100,000 in income, meaning the new total income is $1,400,000

Company C: $200,000 in income, meaning the new total income is $250,000

Step 3: Combining assets, liabilities, equity, income, and expenses

Once intercompany transactions have been eliminated, a consolidated financial statement can be created for Company X. Here’s the result.

Method 3: Equity method of consolidation

Instead of fully consolidating an entity’s financial statements with the parent company, the equity method of consolidation treats the parent’s stake as an investment. This investment is recorded at cost and adjusted as the value of the company changes. A portion of some transactions within the entity may also be consolidated with the parent company’s financial statements, representing the change in that investment’s value.

When to use

The equity method of consolidation is used when the parent company’s stake in an entity is significant enough to influence its daily operations but not enough to be a majority controlling stake. Usually, a company needs to own a 20%-50% stake in another entity to use the equity method of consolidation.

How to use

When using the equity method, an organization needs to follow these steps:

1. Establish the size of the stake in the entity to be consolidated.
2. Add the original value of the investment to consolidated statements.
3. Add a percentage (equal to ownership) of relevant transactions to consolidated statements and the value of the investment.

Pros

The equity method of consolidation comes with some significant advantages.

• More precision: Since you need to report every relevant transaction in this method, your books will paint a clearer picture of how valuable an investment is.
• More investment: Financial consolidation can create tax advantages and other benefits that encourage corporate entities to invest more.
• More complete financial picture: By consolidating the transactions from investments with your main financial statements, you’ll produce a more accurate look into your organization’s performance. Profits from investments can be used to shore up losses in a parent company, for instance.

Challenges

If you need to use the equity method of consolidation, here are some challenges to keep in mind.

• Complex accounting: Because so many transactions need to be reviewed and consolidated into the parent company’s statements, finance teams can spend weeks going through ledgers.
• Dividend reporting: When an entity pays dividends to its investors, it decreases its value. That decrease is reflected in the parent company’s consolidated statements, which can make dividends seem less worthwhile.

Example

Step 1: Establish the stake in each entity to be consolidated

Company X has invested in four different companies: Company A, Company B, Company C, and Company D. Let’s look at its stake in each one.

Company A: 51%

Company B: 35%

Company C: 65%

Company D: 15%

Since Company X owns a majority stake (51%+) in both Company A and Company C, the equity method of consolidation can’t be used—full consolidation would have to be used instead.

That means Company B will be consolidated according to a 35% share, and Company D according to a 15% share.

Step 2: Add the original value of the investment to consolidated statements

Now let’s say Company X paid $50,000 for its share of Company B and $100,000 for its shares in Company D. When it first makes the purchase, it would mark both investments on its balance sheet as $50,000 for Investment in Company B and $100,000 for Investment in Company D.

This is important because that amount is what’s getting modified when consolidating financial statements. Balances for revenues and expenses won’t just be rolled wholesale into the revenues and expenses for the parent company; it’s a little more complicated than that.

Step 3: Add a percentage of relevant transactions to consolidated statements

At the end of every fiscal year, Company X will need to review transactions for Company B and Company D. Some will be consolidated with the value of the initial investment while others will be consolidated with income and expense accounts for Company X. Here are a few examples of these transactions and how they would be handled.

• Company B ends the year with $500,000 in net assets: The finance team at Company X would apply their share of equity (35%) to this amount and add the result ($175,000) to the value of its investment in Company B.
• Company D ends the year with a net liability of $200,000: Company X would add $30,000 (15% of $200,000) to its own liabilities.
• Company D pays out $1,000,000 in dividends to its investors: Company X would add $150,000 (15% of $1,000,000) to its revenue and deduct the same amount from the value of their investment in Company D.

Method 4: Proportionate consolidation

With proportionate consolidation, a parent company adds a portion of the assets, liabilities, equity, revenue, and expenses of companies it has invested in into its financial statements. That portion is equal to the size of the stake it has in that company. It’s done much like a full consolidation but with only a percentage of the subsidiary’s value.

When to use

The short answer? Never. Since 2013, under both the U.S. Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS), the equity method is used in situations where the proportional consolidation method was once appropriate. That means finance teams should never have to use this method.

But historically, the proportional method would be used whenever an organization had a significant stake in another entity without owning a controlling stake (i.e. 20%-50%).

How to use

The proportional method of consolidation follows these steps:

1. Establish the stakes in each entity to know which ones to consolidate.
2. Collect statements for each entity’s assets, liabilities, equity, revenue, and expenses.
3. Take portions equivalent to the percentage of ownership and consolidate.

Pros

Here are some advantages that come with using the proportionate consolidation method:

• Simple to apply: Much like the full consolidation method, this method is simple to apply since you don’t need a transaction-by-transaction operating ledger.
• Easy to understand: While the equity method of consolidation can be more challenging to understand for more junior members of the finance team, this method doesn’t have that problem.

Challenges

Here are some things to keep in mind before using this method:

• Not recognized by regulatory bodies: The proportionate consolidation method has been deprecated in favor of the equity method.
• Not as precise as other methods: While this method is easy to apply, it isn’t as precise as the equity method.
• Time-consuming: Gathering all the financial data you need for this consolidation method can take days.

Example

Let’s look at Company X and the four companies it has a stake in again. Remember, this is how much of each entity Company X owns.

Company A: 51%

Company B: 35%

Company C: 65%

Company D: 15%

Since Company X owns more than 50% of both Company A and Company C, they can’t be consolidated with the proportional method—a full consolidation would be required instead. That means the equity method could only be applied to Companies B and D.

When it comes time to consolidate financial statements, the finance team at Company X needs to look at relevant transactions and apply its percentage stake to each one before adding them to the final statement. Here are some example figures.

After applying the 35% stake to the figures from Company B and the 15% stake to the figures from Company D, you get the following consolidated statement.

How to do it with Prophix

Prophix offers a comprehensive Financial Performance Platform for financial consolidation. It simplifies the process by accommodating companies with multiple subsidiaries, currencies, and accounting standards. Key features include robust audit trails for reliability, language and currency conversion capabilities, and flexible customizations to align with unique business needs.

Prophix also automates data load, validation, and transaction reconciliation. Our collaborative Finanical Performance Platform provides real-time progress tracking for all team members, ensuring an efficient and confident consolidation and close process.

Conclusion: Financial consolidation

No matter which financial consolidation method you use, there’s the potential to get completely swamped with manual work. Financial statements need to be collected, evaluated, and consolidated across companies, which means collaborating with departments that could be multiple time zones away from each other. Doing everything manually isn’t an option. That’s why you need to invest in a platform like Prophix.

Prophix’s Financial Performance Platform integrates seamlessly with your existing data sources. Here’s why it’s your best choice for a financial consolidation platform.

It eliminates complexity

Even the simplest consolidation methods are complex. Manually going through transactions to figure out which ones need to be included in your consolidation can take days—if not weeks. Prophix removes the complexity involved by automating some of the most labor-intensive processes, like multi-currency transactions and sub-consolidations.

It keeps your consolidations compliant

Financial consolidation must abide by requirements set forth by multiple regulatory bodies, and managing compliance can create its own headaches. That’s why Prophix ensures your consolidation remains compliant throughout the process.

Built-in audit reports

Data transparency is essential in financial consolidation. With Prophix, you can create fully customizable audit reports whenever you need them, streamlining your auditing process and accelerating your consolidation.

Want to see what you can do with Prophix for financial consolidation? Watch our demo.