Chapter 10
In This Chapter
Understanding consolidation
Seeing how companies buy companies
Exploring consolidated financial statements
Turning to the notes for details
Like couples who marry and work to combine two incomes, two sets of financial obligations, and two ways of managing money, situations get complicated when companies decide to join forces or buy other companies and combine their financial statements. This new arrangement can make it much harder for you to find out how each piece of this new entity performs financially. In this chapter, I discuss how to read the more complex financial reports that arise when companies consolidate.
One of the ways businesses grow is buying or merging with other companies. When a company buys another, it gobbles up the new one, which loses its identity. But when firms decide to merge, they usually decide jointly how the new company will operate and how to present the financial statements.
Major corporations that own more than 50 percent of a company create financial reports for each division. These entities include subsidiaries, joint ventures, and associates. Here's how they stack up:
If you look at Mattel's or Hasbro's statements online (http://investor.shareholder.com/mattel/financials.cfm; http://investor.hasbro.com/annuals.cfm), you see that each statement indicates that it represents the financial results of the parent company and its subsidiaries. However, you don't see any listing on the balance sheet or income statement of what those subsidiaries are. In fact, unless a company discusses a merger, acquisition, or sale of a subsidiary, associate, or joint venture in the notes to the financial statements, you probably won't see them mentioned individually in the current year's financial report. If no financial transactions occur in the year being reported, the company may only highlight some of its subsidiaries’ successes in the narrative pages in the front of the financial report.
Most companies play a game of cat-and-mouse, hiding relevant data in the notes to the financial statements, hoping that you won't take the time to find it in the small print. Look at the statements for Hasbro and Mattel on their websites. Neither statement mentions which notes are relevant to the line items on their balance sheets or income statements. You have to scour the notes to find out which material is relevant to which parts of each of their financial statements.
One of the most common ways companies grow is to buy up smaller companies. Either these smaller companies get completely gobbled up, with no outward sign that they ever existed, or they become subsidiaries operating under the umbrella of the firm that bought them.
A company can take control over another company by using any of three different methods: statutory merger, statutory consolidation, or stock acquisition. Only when a company buys another using the stock acquisition method does it become a subsidiary. Here's a brief overview of the ways one company can buy another:
Two types of stock acquisition exist:
Subsidiaries are the entities left in place after a company acquires another company using the stock acquisition method. If you were a shareholder in the subsidiary before it was bought out, you won't find tracking the company that you originally owned easy. Instead, you'll find that most of the financial detail is now just part of the consolidated financial statements of the larger firm.
Acquiring a company through stock acquisition is also easier than using the other takeover methods because the company's shares are sold on the open market. One company can take over another simply by buying up those open-market shares.
Most major corporations are made up of numerous companies bought along the way to create their empires. The financial statement for such a corporation reflects the financial results for all these entities it bought, as well as the original assets of the company.
After a stock acquisition by the parent company, the subsidiary continues to maintain separate accounting records. But in reality, the parent company controls the subsidiary, so it no longer operates completely independently. By accounting rules, the parent company must present its subsidiary's and its own financial operations in a consolidated manner (even though the two companies may be separate legal entities). The parent company does so by publishing consolidated financial statements, which combine the assets, liabilities, revenue, and expenses of the parent company with those of its affiliates (that is, its subsidiaries, associates, and joint ventures).
When a company owns all the common stock of its subsidiaries, it doesn't need to publish reports about the subsidiaries’ individual results for the general public to peruse. Shareholders don't even need to know the results of these subsidiaries.
In preparing consolidated financial statements, the parent company must eliminate numerous transactions between itself and its affiliates before presenting the statements to the public.
For example, the parent company must eliminate such transactions for accounts receivable and accounts payable, to avoid counting revenue twice and giving the financial report reader the impression that the consolidated entity has more profits or owes more money than it actually does. Other key transactions that a parent company must eliminate when preparing consolidated financial statements include the following:
However, the consolidated income statements can't show these sales as revenue and can't show the purchases as expenses. Otherwise, the company is double-counting the transaction. Accounting rules require that parent companies eliminate these types of transactions.
As you can see, these major transactions are all critical for determining whether a company made a profit or loss from its activities. Eliminating assets, liabilities, revenue, and expenses from public view makes determining a subsidiary's financial results nearly impossible for shareholders or creditors. But if these transactions are included, the value of the parent company's stock is distorted because the transactions are counted twice. The shareholders of the parent company can't know the true value of the company's assets and liabilities in such a case; the income statement doesn't reflect the company's true revenues and expenses.
The eliminations to adjust for reporting subsidiary results mentioned in the previous section don't show up in the parent company's financial reports unless some portion of the stock acquisition takes place in the year that's being reported. When the acquisition or some financial impact of that acquisition does take place in the year that's being reported, you need to look to the notes to the financial statements to get details about any financial impacts.
In the first note to the consolidated financial statement, the company indicates that the financial statements represent the results of the parent company, not its affiliates. The company also includes some statement about the eliminated transactions. Just to give you an example of how this is worded, here's the information from GE's notes.
Note that you don't find out what subsidiaries fall under GE in this explanation. You don't find that detail in Mattel's or Hasbro's notes, either, as I discuss in Chapter 9. Few companies provide that detail. Sound like a confusing house of cards? Yep, it sure is, which is what makes reading consolidated financial statements so difficult!
If a company completes a merger or acquisition in the year that's reported on the consolidated financial statement, you find a special note in the notes to the financial statements. Otherwise, if you want to find out any details about how the mergers and acquisitions may still be impacting the company financially, you have to start digging.
You can see how you need to play a game of cat-and-mouse to find all the little pieces of cheese laid out in the financial statements. Companies don't make information easily accessible, and they often hide the financial impact of an acquisition or merger on the value of your shares by writing the notes to the financial statements in such a convoluted way that you have to be a detective to sort out the relevant details.
Another important note you can check out to find the impact of mergers and acquisitions on the consolidated financial statements is the note that explains goodwill. Goodwill is the amount of money a company pays in excess of the value of the assets when it buys another company (see Chapters 4 and 6 for more details). For example, suppose a company has $100 million in assets, and another company offers to buy it for $150 million. The extra $50 million doesn't represent tangible assets like inventory or property; it represents extra value because of customer loyalty, store locations, or other factors that add value. Goodwill is a factor only in the case of a merger or acquisition that involves acquiring 100 percent of the subsidiary or other affiliate.
Whenever a company sells a subsidiary or other affiliate or discontinues its operations, a note to the financial statements regarding this transaction appears in the year in which the transaction first occurred. After the first year, any impact that a sale or a discontinuance of operations has on a company's operating results is usually buried in other notes. Just like with mergers and acquisitions, you have to play detective to find out any ongoing impact that these changes have had on the company.
The company includes information in the notes about any profits or losses related to the liquidation of an asset or discontinued operations. Because these transactions can impact financial statements over a number of years, the fine print includes financial impacts for the years prior to the year being reported, as well as anticipated future impacts.
You may find notes related to impacts on the balance sheet, income statement, shareholders’ equity, or cash flows. Transactions involving affiliates can impact any of these statements.