Discuss the accounting for majority, active investments

MAJORITY, ACTIVE INVESTMENTS

When one firm, P, owns more than 50% of the voting stock of another company, S, P can control the activities of S in terms of both broad policy making and day-to-day operations. Common usage refers to the majority investor as the parent and to the majority-owned company as the subsidiary. U.S. GAAP and IFRS require the parent to combine the financial statements of majority-owned companies with those of the parent in consolidated financial statements.

REASONS FOR LEGALLY SEPARATE CORPORATIONS

Business firms have several reasons for preferring to operate as a group of legally separate corporations, rather than as a single entity. From the standpoint of the parent company, the more important reasons for maintaining legally separate subsidiary companies include the following:

1 . To reduce the parent's legal or operational risk.

Separate corporations may mine raw materials, transport them to a manufacturing plant, produce the product, and sell the finished product to the public. If any one part (subsidiary) of the total process proves to be unprofitable or inefficient, losses from insolvency will fall only on the owners and creditors of the one subsidiary corporation. (Some drug firms acquire subsidiaries to make and market medical products in the hope that if something goes wrong in future years, the parent firm will not be liable for harm to the subsidiary's customers. Individuals who believe the subsidiary's products have harmed them often sue the parent and sometimes succeed in obtaining legal relief from the parent.)

2 . To reduce the costs of dealing with jurisdiction-specific differences in corporate laws and tax rules.

An organization that does business in a number of localities faces overlapping and inconsistent taxation and regulations. Organizing legally separate corporations to conduct operations in the various locales can reduce the administrative costs of dealing with location-specific rules.

3 . To expand or diversify.

A firm may enter a new line of business, or expand an existing line, by acquiring a controlling interest in another company's voting stock. This approach may be faster, less expensive, and less risky than constructing a new plant or starting a new line of business.

4 . To reduce the costs of divesting assets.

Firms generally save costs if they sell the common stock of a subsidiary rather than trying to sell each of its assets separately. In addition, a sale of shares transfers all known and, perhaps, unknown liabilities to a buyer.

PURPOSE OF CONSOLIDATED STATEMENTS

For various reasons, then, a single economic entity may exist in the form of a parent and
several legally separate subsidiaries, often referred to as an affiliated group. A consolidation
of the financial statements of the parent and each of its subsidiaries presents the results of operations, financial position, and cash flows of an affiliated group of companies under the control of a parent as if the group of companies composed a single entity. The parent and each subsidiary are legally separate entities that operate as one centrally controlled economic entity. Consolidated financial statements generally provide more useful information to the shareholders of the parent corporation than do separate financial statements for the parent and each subsidiary.

Consolidated financial statements also provide more helpful information than does the equity method, because they include all the assets, liabilities, revenues, and expenses of the controlled subsidiaries, not just the investment account that represents the parent's investment in the subsidiary's common shareholders' equity and not just the parent's share of the subsidiary's net income. The parent, because of its voting interest, can control the use of all of the subsidiary's assets. The parent needs to own only a majority of the voting stock, not necessarily 100%, to control the use of 100% of the subsidiary's assets. Consolidation of the individual assets, liabilities, revenues, and expenses of both the parent and the subsidiary provides a more realistic picture of the operations and financial position of the single economic entity.

The separate financial statements of the parent and its subsidiaries form the base for consolidated financial statements. In a legal sense, therefore, consolidated statements supplement, and do not replace, the separate statements of the individual corporations. Published annual reports may contain only the consolidated statements.