What it means
Normally, when one company controls another, accounting standards require consolidation. The parent combines the two sets of figures as if they were a single business, so readers see the full assets, debts and sales of the group.
An unconsolidated subsidiary is one left out of that combination. There are a small number of reasons this can happen.
Control may be temporary or restricted, for example by a legal dispute, bankruptcy proceedings or tight local government controls over cash, and some regimes also exempt investment entities, which measure their holdings at fair value instead. The exact rules depend on the accounting framework used.
When a subsidiary is not consolidated, the parent usually reports the investment using the equity method or at cost or fair value. Under the equity method, the investment starts at cost, rises by the parent's share of the subsidiary's profit, and falls by dividends received.
This keeps the profit visible but hides the subsidiary's debts from the group balance sheet. That hidden debt is the main concern for analysts.
A parent can look less indebted than it truly is if a large borrowing sits in an unconsolidated vehicle, and some famous corporate failures involved debts kept off the main balance sheet. Careful readers look at the notes to find out what guarantees, loans or commitments the parent has given to the unconsolidated company.
For managers, the point is to ask whether the exclusion is justified and what exposure remains. Even where the numbers are not combined, the parent can still lose money through its investment, its loans to the subsidiary and any guarantees it has signed.
Auditors test the decision carefully, because leaving a controlled company out of the group accounts can flatter reported debt and profit. They look for evidence about who appoints the directors, who controls the bank accounts and whether the parent can use the subsidiary's assets for its own benefit.
The conclusion must be documented and reviewed again each year.
In practice
Real-world examples.
Example
A mining group owns 70% of a foreign company operating in a country that has frozen the transfer of cash overseas. Management cannot direct its operations, so the group excludes it from consolidation and reports it as an investment.
Example
A bank holds a majority stake in a company that is in formal insolvency proceedings. Because a court-appointed administrator now controls the company, the bank stops consolidating it and records the investment at a reduced value.
Example
A property group sets up a vehicle to own a $40,000,000 building and keeps the vehicle off its consolidated balance sheet by sharing control with partners. Analysts ask for details of the debt and any guarantees in the notes, because the group may be called on to repay the debt if the vehicle cannot.
Formula
Calculation
Equity method carrying value = Initial investment + Share of net income - Dividends received
A parent invests $5,000,000 in a subsidiary it owns 60% of but does not consolidate. The subsidiary earns net income of $1,000,000, so the parent's share is 0.60 x 1,000,000 = $600,000. The subsidiary pays total dividends of $200,000, and the parent receives 0.60 x 200,000 = $120,000. The carrying value is 5,000,000 + 600,000 - 120,000 = $5,480,000.Case study
Seen in the real world.
Stonewall Industries is an illustrative, fictional manufacturer that owned 55% of a foreign distribution company. Local regulators froze the distributor's accounts for two years, and the parent lost the practical ability to direct its activities.
The auditors concluded that control no longer existed in substance, so the distributor was removed from the consolidation and shown as a single investment line. The group's reported sales fell by $30,000,000, while the investment was tested for impairment and written down by $4,000,000.
The illustrative lesson is that deconsolidation changes the headline numbers without changing the underlying economics. Stonewall's notes explained the reasons, listed a $6,000,000 loan to the distributor, and told readers what would happen if control were restored. Lenders to the group asked for a separate schedule of the exposure, which the finance team prepared each quarter.
Watch out
Common mistakes.
- Assuming that an unconsolidated subsidiary has no effect on the parent, when loans, guarantees and impairment can still create losses.
- Treating consolidation as optional, when most accounting standards require it unless a specific exception applies.
- Ignoring the notes, where debts and commitments linked to the excluded company are disclosed.
Questions
People also ask.
Why would a company leave a subsidiary out of the consolidation?
Typical reasons include loss of control, temporary control or investment entity status, and each case must meet the rules of the accounting framework.
How is the investment reported instead?
Usually using the equity method, at cost, or at fair value, depending on the rules and the facts.
Does this make the group look healthier?
It can, because the subsidiary's debts are not shown, which is why readers should check the notes for guarantees and commitments.
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