ARB 51: Rules for Consolidated Financial Statements

Accounting Research Bulletin (ARB) 51, issued in 1959, established the principle that consolidated financial statements are the most meaningful presentation when one company has a controlling financial interest in another. Combining the financial reports of a parent and its subsidiary into a single set of statements is considered a fairer presentation than separate reports. The concepts introduced in ARB 51 have since been integrated into the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC), primarily within Topic 810, Consolidation.

The Principle of Control

A controlling financial interest, the trigger for consolidation, is most commonly identified through the ownership of a majority voting interest. If a parent company owns more than 50% of a subsidiary’s outstanding voting shares, it is presumed to have control. This ownership level provides the power to direct the subsidiary’s significant activities, including electing its board of directors and setting its policies.

For instance, if a parent acquires 70% of a subsidiary’s common stock, it holds a majority of the voting rights. This position allows the parent to govern the subsidiary’s actions, making consolidation appropriate.

While control through majority ownership is a clear concept, modern business arrangements can be more complex. ASC 810 has evolved to address situations where control is exercised through means other than a direct majority of voting shares, such as through contractual arrangements. These situations often involve what are known as variable interest entities (VIEs), though the majority voting interest model remains the most common basis for consolidation.

The Consolidation Process

The consolidation process begins by aggregating the financial statement line items of the parent and subsidiary. This means 100% of the subsidiary’s assets, liabilities, revenues, and expenses are added to the parent’s corresponding accounts, regardless of the parent’s exact ownership percentage.

The elimination of intercompany transactions and balances is a subsequent step. This is necessary because the consolidated statements are meant to portray the group as a single economic entity, and failing to eliminate these transactions would result in double-counting. For example, if the parent company sells inventory to its subsidiary, the revenue recorded by the parent must be eliminated in consolidation to avoid overstating revenue and expenses.

Similarly, other intercompany balances must be removed, such as a loan between a parent and subsidiary. Another elimination involves the parent’s investment account in the subsidiary. This asset on the parent’s books is eliminated against the equity accounts of the subsidiary to prevent the double-counting of the subsidiary’s net assets.

Accounting for Noncontrolling Interest

When a parent company controls a subsidiary but owns less than 100% of its voting stock, a noncontrolling interest (NCI) arises. The NCI represents the portion of the subsidiary’s equity, or net assets, that is owned by the other shareholders. For example, if a parent owns 80% of a subsidiary, the remaining 20% is the noncontrolling interest.

On the consolidated balance sheet, the noncontrolling interest is presented as a separate component of total equity, distinct from the equity attributable to the parent’s shareholders. This presentation clarifies that although the parent controls all of the subsidiary’s assets and liabilities, a portion of the claim on those net assets belongs to outside owners.

On the consolidated income statement, the total consolidated net income includes 100% of the subsidiary’s net income. This total must then be allocated between the controlling and noncontrolling interests. The statement must clearly show the portion of net income attributable to the parent company’s shareholders and the portion attributable to the NCI.

Required Disclosures

Companies must include specific disclosures in the notes to the consolidated financial statements. A requirement is the disclosure of the consolidation policy being followed, which includes identifying which subsidiaries are included and the basis used to determine control for each one.

Disclosures must also detail any changes in the parent’s ownership interest in a subsidiary and how those changes were accounted for. If a parent’s ownership stake changes but it maintains control, the transaction is treated as an equity transaction and must be disclosed as such.