Subsidiary accounting: A guide to the equity and consolidated methods

Did you recently acquire (or plan to form) a new subsidiary company? Are you scouring the Internet for information on accounting and bookkeeping best practices for your company structure? Well, you’ve come to the right place, because this blog has subsidiary accounting info galore. 

In this blog, we’ll cover the pros and cons of subsidiaries, important accounting practices for subsidiaries, and the different bookkeeping methods required for this business type. Buckle up and let’s go!

What is a subsidiary?

First things first: let’s define our terms to make sure we’re all on the same page. 

• A subsidiary (aka a joint company structure) is owned and/or controlled, either fully or partially (at least 50%), by another company (called the parent company). 
• A parent company is a single  company that owns the subsidiary or subsidiaries. 

The parent company and the subsidiary company should have different bank accounts, distinct tax account numbers (EINs), and separate operations. This means the parent company and the subsidiary company will have different accounting records and books, but we’ll chat more about financial statements later. 

Let’s get into some examples now. Let’s say Company A buys 55% of Company B. Company A becomes the parent company and now has controlling ownership in Company B, the subsidiary company. Another example: Company C decides to form a new company, Company D. Company C is the parent, and Company D is the subsidiary. 

Now, here are some famous real-life examples of parent companies and their subsidiaries:

• Pepsi, Frito-Lay, Doritos, and more are subsidiaries of PepsiCo., the parent company. 
• Marvel, Disney Channel, and ABC Television Group are subsidiaries of the Walt Disney Company.
• Band-Aid, Aveeno, Tylenol, and Neutrogena are subsidiaries of Johnson & Johnson.

Advantages of subsidiaries

Now that we’ve gone over what a subsidiary is, let’s cover what the advantages are, including some you may not have thought of when you first formed or acquired a subsidiary.

Protects the parent from liabilities

Forming a subsidiary can be a smart way to protect one part of the business from the risks and obligations of another part of the business placed in the subsidiary. For example, if the parent company sells and distributes explosives for mining purposes, and one explosive is riskier than the others, transferring the business operations and intellectual property associated with the riskiest explosive to the subsidiary can protect the rest of the parent's assets from legal claims and damages.

Tax advantages

There may be different ways subsidiaries can take advantage of lower tax rates. Instead of paying tax on the entire profits of both the parent and its subsidiaries in one jurisdiction, subsidiaries may only be responsible for their country and/or state taxes where it operates (with the proper planning, that is!). Additionally, in certain countries, like the United States, the parent company and the subsidiary can combine to file a consolidated tax return, which can help them save on taxes. When dealing with taxes, it’s always best to consult with your tax advisor first before creating the subsidiary. Unfortunately, there could be tax traps with subsidiaries that actually increase overall taxes instead of saving them… So yeah, check with your tax advisor!

Different company culture

The company culture and structure of a subsidiary might not necessarily be the same as its parent company or other subsidiaries, which can be a good thing! A certain management style or culture may work for one company, but not the other. For example, if the subsidiary and parent company are in different countries, this separation also allows for each company to use the appropriate management style for their location.

Different markets

If the parent company and the subsidiary are serving different customers, then they can each keep their own branding and marketing to appeal to their unique customer bases. Appealing to two different customer markets also means more profits coming in from more sources, which is a win-win.

Subsidiary accounting: The equity method vs. the consolidated method

Doing accounting for subsidiaries can be complex, but we’ll walk through it together. The two most common bookkeeping methods for a subsidiary are the equity method and the consolidated method. The parent company can ultimately decide whether to report the investment in a subsidiary using the equity method or consolidate for its internal financial statements. Note: This may not be the case for audited financial statements where accounting rules need to be strictly followed!

The equity method is best used for investments of between 20% to 50% or significant influence in a company or joint venture, but not over 50% ownership. If you own a small business, you may choose to use the equity method even in the event of 100% control over the subsidiary if consolidated financial statements are not necessary. But before we start getting ahead of ourselves, let’s go over what the differences are between the equity method and the consolidated method.

The equity method for subsidiary accounting

Parent companies use the equity method to record the revenue from their subsidiary company (or companies), which goes on their non-consolidated income statements. The parent company’s investment is initially recorded at cost. Let’s say the parent company owns 58% of its subsidiary, and the subsidiary has a net income of $1,000,000. The parent company would report $580,000 as a debit (an increase) to the Investment in Subsidiary Asset Account and a credit to the Investment Income Account.

After that, the carrying amount is adjusted each fiscal period for the investor’s proportionate share of change of the investment. Additionally, if the subsidiary’s value increases in net worth, the value of the subsidiary may increase drastically.

Okay, example time! This time, with a table⁠—get excited. 🎉 Let’s say a parent company acquires 25% of a subsidiary company for a market value of $100. Here’s what the equity method would look like:

Subsidiary reports $500 profit for the year⁠—Parent company receives 25% of $500

Based on Schedule K-1

If there is cash distribution

The consolidated method for subsidiary accounting

The consolidated method is usually preferred over the equity method if the percentage the parent company owns is on the higher side (more than 50%, or if it controls the subsidiary). 

The consolidated method is the process of eliminating entries that would double the overall value of the subsidiary. In simple terms, the consolidation method involves the parent and subsidiary’s financial statements being (wait for it…) consolidated in one set of financial statements, which includes consolidated balance sheets and income statements. Any overlapping transfers, payments, and loans need to be removed or eliminated. If these adjustments aren’t made, the companies’ financial statements would not only look wonky, but be inaccurate as well. 

Tip: The consolidated method should be generated using an Excel spreadsheet and, for example, cannot be generated using the parent or subsidiary Wave accounts. Excel is a handy tool to use because of its consolidate feature, which lets you select data from multiple workbooks and combine them in one place. Wave Accounting can’t add two or more companies' reports, so parent and subsidiary data can’t be merged. If you’re a Wave Accounting user, you will need to download the data and merge data into one combined Excel file.

LLC subsidiary tax implications

Now, let’s talk specifically about LLCs. LLC stands for “limited liability company”; it’s a U.S. business structure that protects its owner(s) from being personally responsible for (you guessed it) liabilities or debts of the business. Therefore it is best from a legal perspective for each LLC to have its own bank accounts and set of books to keep their own assets separate from other entities. An LLC is economically responsible up to the value of the assets it owns. LLCs are a popular choice for corporations starting a new subsidiary because they’re relatively easy to set up. 

LLCs, in general, have a pass-through taxation model which means they allocate their income, losses, credits, and deductions to their legal owners, who include these items on their tax returns. LLCs, by default, do not pay U.S. federal income tax as separate entities; pass-through subsidiary activity will flow to the parent.

Let’s go over an example of what a pass-through would look like. If an LLC has more than one member, it will file a 1065 form partnership return and report its net profit to the members with a Schedule K-1. Members use the K-1 to include the income and expenses generated by the LLC on their personal tax returns. 

If the ultimate parent company is an individual, as mentioned above, they will report this activity on their tax return. If they are the sole owner, they will use a Schedule C attached to their form 1040 return. If they are a partial owner, they will pick up the activity from the Schedule K-1 received on the ‘Other income’ line of the form 1040 (page 1, line 8).

If the LLC is owned by a corporation, it will include its share of profit or loss in the owner’s tax return. If the LLC is wholly owned 100% by one corporation by default, the LLC is disregarded for federal tax purposes and does not file a separate return from its owner. If it is partially owned, as mentioned above, it will file Form 1065 for a partnership return because it has more than one member.

An LLC can also elect to file as a corporation for tax purposes. The election must be made within 75 days of its effective date. Once the election is made, it may be subject to corporate income tax and a separate corporate tax return will be required.

An LLC can be accounted for by both the equity and consolidated method of financial statement reporting. However, we strongly suggest letting your tax preparer know so they know to make any necessary tax adjustments.

Disadvantages of subsidiaries

We’ve sung the praises of subsidiaries, so it’s only fair we get into the disadvantages now. Even if you’ve already gone ahead with forming or acquiring a subsidiary, it’s a good idea to be aware of the possible hurdles you might face so you can prepare yourself going forward.
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Conflicts
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The subsidiary and parent company may not agree on decisions, which can cause conflict between the two companies. The relationship between parent and subsidiary is in and of itself already complicated, so decision making might be slowed down.

Limited control

Possible bad news for the parent companies in the room: You may not have full control over the subsidiary, including things like management and access to funds.

Parent not fully protected

Subsidiaries aren’t a means for the parent company to evade all responsibility. The parent company may need to guarantee to pay off debts or take out loans for the subsidiary. Additionally, the parent company may still be liable for the operations of its subsidiary, especially if the subsidiary is engaging in any illegal activities (but we can assume that isn’t going to be a problem here, right?). In some cases, if the subsidiary is involved in a scandal or goes into a ton of debt, this may also affect the parent’s reputation.

More paperwork

Remember what we said about the parent and subsidiary relationship being complicated? This can result in more legal and accounting paperwork that needs to be done, not to mention additional tax returns and filings. I know we’ve said this a million times before, but it’s best to contact an accountant and tax professional for assistance!

Need more help with subsidiary accounting?

If all of this info about subsidiary accounting is giving you a headache, don’t worry; it can take a while to wrap your head around the equity and consolidated methods. Here’s a recap of everything we covered:

• A subsidiary is owned, either fully or partially ( at least 50%), by a parent company.
• Forming or acquiring a subsidiary can provide tax advantages and protection from liabilities, but can also make decision making and paperwork more difficult. 
• Two popular options for accounting are the equity method and the consolidated method. 
• Parent companies use the equity method to record the revenue from their subsidiary company, which is adjusted each fiscal period. 
• The consolidation method combines the parent and subsidiary’s financial statements into one set, with any overlapping factors being eliminated to ensure their financial statements are accurate. 
• LLCs have a pass-through taxation model. Pass-through subsidiary activity will flow to the parent for tax purposes.
• Taxation of subsidiaries and LLCs may be complicated. Contact a tax professional for assistance. 

That’s a lot of information, so pat yourself on the back for making it this far! If you have questions about subsidiary accounting, financial statements, or personal questions about your small business, our Wave Advisors team of tax professionals can provide you with personalized, 1:1 assistance.

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