In the world of finance and accounting, the term “subsidiary undertaking” holds significant importance for investors, companies, and regulators alike. It’s one of those concepts that may seem intimidating at first glance, but with a closer look, it becomes clearer and more relevant to both the corporate structure and financial reporting process. In this guide, I’ll walk you through the concept of a subsidiary undertaking in simple terms, explore its implications for financial statements, and help you understand how it fits into the broader context of corporate structure and governance.
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What is a Subsidiary Undertaking?
A subsidiary undertaking is essentially a company that is controlled by another company, known as the parent company. The parent company holds a significant share of the subsidiary’s stock, typically more than 50%, thereby gaining control over its operations, finances, and decision-making processes. In this arrangement, the parent company is considered the “parent” because it exercises control over the subsidiary, often through direct ownership or through other means like voting rights, while the subsidiary is the “child” that operates under the umbrella of the parent’s authority.
It’s important to note that the term “undertaking” in this context refers to the legal entity or business activity of the subsidiary. The subsidiary can be a private limited company, a public limited company, or any other form of business entity depending on the legal structure adopted by the companies involved.
Control and Ownership
One of the central concepts of a subsidiary undertaking is control. Control typically arises when the parent company owns more than 50% of the subsidiary’s voting shares. This control gives the parent company the power to dictate the subsidiary’s policies and make strategic decisions, including financial, operational, and managerial decisions. However, control doesn’t necessarily require a majority shareholding in some cases. In certain scenarios, control can be exercised with less than 50% of the shares, if the parent company can exert influence over decisions through voting rights or other agreements.
Here are some scenarios where control can be established:
- Majority Ownership: A parent owns over 50% of the subsidiary’s voting shares. This is the most straightforward case of control.
- Non-Majority Ownership with Control: Even if a parent owns less than 50% of shares, it may still control the subsidiary if it holds significant voting power or influence (for example, through board representation or special voting rights).
- Special Agreements or Contracts: Sometimes, a parent company may not own the majority of shares but may still gain control through special agreements that allow it to appoint the majority of the board members or have the final say on critical decisions.
Financial Reporting and Consolidation
One of the most significant implications of having a subsidiary undertaking is the requirement for consolidated financial statements. The parent company, which controls the subsidiary, must report the financial activities of both the parent and the subsidiary as if they were a single economic entity. This consolidation is important for providing a clearer picture of the overall financial health of the group as a whole, rather than just focusing on the parent company’s finances.
The process of consolidation involves combining the financial statements of the parent company with those of the subsidiary, eliminating any intra-group transactions (such as sales between the parent and the subsidiary), and adjusting for any differences in accounting policies. This allows stakeholders to get an accurate representation of the financial performance and position of the entire group.
Here’s a simplified example:
Let’s say Company A is the parent, and it owns 80% of Company B, which is a subsidiary. Company A must combine its financial statements with Company B’s statements for purposes of reporting to shareholders and regulators. This includes aggregating revenue, expenses, assets, liabilities, and equity, while eliminating intercompany transactions, such as any sales from Company A to Company B.
The Impact of Subsidiary Undertakings on the Parent’s Financial Statements
The presence of subsidiary undertakings can affect a parent company’s balance sheet, income statement, and cash flow statement in several ways:
- Balance Sheet: A parent’s balance sheet will include the assets and liabilities of the subsidiary. If the subsidiary has significant assets (like property or machinery), these will be added to the parent’s balance sheet under the consolidated financial statements. Similarly, any liabilities incurred by the subsidiary will be included as part of the parent’s consolidated liabilities.
- Income Statement: On the income statement, the revenue and expenses of the subsidiary are consolidated with those of the parent. Any income generated by the subsidiary will be included in the consolidated revenues of the group. However, expenses related to the subsidiary’s operations will also be added to the parent’s income statement.
- Cash Flow Statement: Cash inflows and outflows associated with the subsidiary will be included in the parent’s consolidated cash flow statement. This could include cash received from the subsidiary or payments made to it for services, goods, or debt servicing.
Examples of Subsidiary Undertakings in Practice
To better understand how subsidiary undertakings work in the real world, let’s look at some examples from well-known companies.
Example 1: Apple Inc. and its Subsidiaries
Apple Inc., a U.S.-based technology giant, has a wide range of subsidiary undertakings worldwide. Apple owns and controls various subsidiaries, such as Beats Electronics, Anobit Technologies, and Emagic. These companies operate independently but are fully controlled and owned by Apple, contributing to its overall revenue and growth. On Apple’s consolidated balance sheet, all assets, liabilities, and profits from these subsidiaries are combined with those of the parent company.
Example 2: Berkshire Hathaway and Its Subsidiaries
Berkshire Hathaway, Warren Buffett’s investment company, is another example of a corporation with numerous subsidiary undertakings. Berkshire Hathaway owns companies in diverse sectors, including GEICO, Duracell, and NetJets. These subsidiaries operate independently in their respective industries but are fully controlled by Berkshire Hathaway. The financial results of these companies are included in Berkshire Hathaway’s consolidated financial statements, giving investors a holistic view of the company’s total financial performance.
How Subsidiary Undertakings Affect the Parent’s Strategy
The parent company’s overall strategy may be significantly influenced by its subsidiary undertakings. Subsidiaries often operate in different markets or industries, allowing the parent company to diversify its portfolio and reduce risk. This strategy is known as conglomerate diversification. For example, Berkshire Hathaway’s diverse subsidiaries in insurance, energy, and consumer goods provide it with a stable source of revenue even if one market faces a downturn.
A parent company may also use subsidiaries to pursue specific business objectives, such as entering new markets, launching new products, or testing new technologies. Subsidiaries are often used to shield the parent company from risks in the subsidiary’s operations. For instance, if a subsidiary faces a legal issue or financial losses, the parent company may be insulated from these problems, depending on the legal structure and financial arrangements.
Key Differences Between Parent and Subsidiary Companies
| Aspect | Parent Company | Subsidiary Company |
|---|---|---|
| Ownership | Owns controlling interest (>50%) | Controlled by parent company |
| Control | Makes strategic decisions | Operates under parent’s control |
| Financial Reporting | Prepares consolidated financials | Prepares separate financials |
| Liabilities | Liable for own operations | Liabilities shared with parent |
| Profit Sharing | Receives dividends from subsidiary | May remit profits to parent |
Legal and Tax Considerations
There are also legal and tax implications when it comes to subsidiary undertakings. In many jurisdictions, including the U.S., subsidiaries are treated as separate legal entities from their parent companies. This means that subsidiaries can enter into contracts, incur liabilities, and pay taxes independently of their parent.
From a tax perspective, the parent company may benefit from consolidated tax filing, where the parent and its subsidiaries are taxed as a single entity. This can lead to tax advantages, such as offsetting losses from one subsidiary against the profits of another. However, the rules governing this vary by jurisdiction and require careful planning to ensure compliance.
Conclusion
In conclusion, a subsidiary undertaking is a crucial concept for understanding corporate structures and financial reporting. These entities allow businesses to expand and diversify their operations, while also providing a clear view of the financial health of a larger group. As an investor, business owner, or corporate professional, understanding how subsidiary undertakings work is essential for navigating the complexities of modern business. By recognizing the impact of control, consolidation, and reporting, you can better appreciate the dynamics of corporate ownership and the strategies employed by parent companies in managing their subsidiaries.
