In this video, we walk through 5 FAR practice questions teaching about adjusting consolidated financial statements to correct errors. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Adjusting Consolidated Financial Statements to Correct Errors
Consolidated financial statements provide a comprehensive view of the financial position and performance of a parent company and its subsidiaries as a single economic entity. However, errors can occur in consolidation due to the complexity of combining multiple financial statements. Adjusting these statements to correct errors is crucial for accurate financial reporting.
Common Corrections in Consolidated Financial Statements
- Elimination of Intercompany Transactions:
- Nature of Error: Intercompany transactions, such as sales, loans, or balances between the parent and subsidiary, should be eliminated to avoid double-counting.
- Correction Example: If the parent company, Summit Holdings, sells goods to its subsidiary, Valley Corp, for $100,000, this transaction must be eliminated. If Valley Corp reports an account payable of $100,000 to Summit Holdings, and Summit Holdings reports an account receivable of $100,000 from Valley Corp, both should be removed in consolidation.
- Investment in Subsidiary:
- Nature of Error: The parent company’s investment in the subsidiary should be eliminated against the subsidiary’s equity to prevent double counting.
- Correction Example: If Sunset Ventures has an investment of $400,000 in Dawn Enterprises, which is also reflected as equity in Dawn’s financial statements, this investment should be eliminated during consolidation to avoid overstating assets.
- Unrealized Intercompany Profit:
- Nature of Error: Profits from intercompany sales that remain unrealized at the consolidated level must be eliminated.
- Correction Example: If Clearwater Holdings sells equipment to its subsidiary, Lakeview Inc., for $90,000 (original cost $70,000), and the equipment is unsold to third parties, the $20,000 profit should be eliminated in consolidation.
- Non-controlling Interest (NCI):
- Nature of Error: When the parent owns less than 100% of a subsidiary, only the parent’s share of the subsidiary’s net income should be included in consolidated retained earnings, while the NCI should be reported separately.
- Correction Example: If Summit Holdings owns 75% of Meadow Corp and reports all of Meadow’s net income in the retained earnings consolidation, it needs to adjust to reflect only its share, excluding the 25% attributable to non-controlling interest.
- Elimination of Duplicate Assets and Liabilities:
- Nature of Error: Duplicate assets and liabilities can occur if intercompany balances are not eliminated correctly.
- Correction Example: A loan from Blue Ocean Corp to its subsidiary, Green Mountain Inc., for $80,000 should be eliminated by removing the accounts receivable from Blue Ocean’s balance sheet and the accounts payable from Green Mountain’s.
Key Rules for Adjusting Consolidated Financial Statements
- Single Economic Entity: Consolidated financial statements should present the parent and subsidiaries as a single economic entity, reflecting only external transactions.
- Uniform Accounting Policies: Ensure that all entities within the group apply consistent accounting policies.
- Intercompany Eliminations: All intercompany transactions and balances must be eliminated in full.
- Non-controlling Interest: Properly account for non-controlling interests, reflecting only the parent’s share of net income and equity.
Examples of Correcting Errors in Consolidated Financial Statements
Example 1: Intercompany Loan Elimination
Riverside Corp has provided a loan of $100,000 to its subsidiary, Riverbank Ltd. At year-end, Riverside reports this as an account receivable, while Riverbank reports it as an account payable.
Correction:
- Eliminate the $100,000 from both the accounts receivable and accounts payable in the consolidated statements.
- This adjustment ensures that the loan is not double-counted as both an asset and liability.
Example 2: Intercompany Sales Elimination
Horizon Inc. sells inventory worth $150,000 (cost $120,000) to its subsidiary, Skylight Co. By year-end, Skylight has sold 60% of the inventory to external customers.
Correction:
- Calculate intercompany profit: $150,000 – $120,000 = $30,000.
- Recognize external profit based on sales to third parties: 60% of $30,000 = $18,000.
- Eliminate the remaining $12,000 profit in the consolidated inventory as it is unrealized.
Example 3: Investment in Subsidiary Elimination
Sunset Enterprises has an investment of $500,000 in its subsidiary, Dawn Corp, and reports it as an asset. Dawn Corp’s equity includes this amount.
Correction:
- Eliminate the $500,000 investment from Sunset’s assets and from Dawn’s equity in the consolidated statements.
- This adjustment ensures the net assets and liabilities reflect only external interests.
Conclusion
Adjusting consolidated financial statements to correct errors is vital for accurate financial reporting. By eliminating intercompany transactions, correctly accounting for investments and non-controlling interests, and ensuring consistent accounting policies, financial statements can accurately reflect the true economic position of the parent and subsidiary as a single entity. Consistent review and adjustment of consolidated statements are essential to maintain transparency and reliability in financial reporting.
