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| Arqala Minor with the Prep School's Beloved Accounting Teacher Mr. Debits I studied hard then so I could answer your questions today. |
I promise you it won’t be. Can’t promise much on length though.
The real point of this post is the second part of the title.
You may be thinking why should I care?
After all the accountants will do their job and “account”.
“Why should I care anymore about this than the recipe the hummus chef at Hummus Express uses?
The reason you should care is that consolidated financials are not the financials of a legal entity rather they are the financials of an “economic entity”.
An economic entity that the accountants have “constructed” according to certain (accounting) principles.
From a legal standpoint, this entity exists solely on the pages of a financial report.
Consolidated financials are designed to give a picture of the position and performance of the economic entity or group.
But they can also be misleading, if one doesn't know what they represent.
In the real world, one conducts business with legal entities not accounting constructs.
One buys the stock or debt of a legal entity. One signs other contracts with a legal entity.
Contracts with legal entities are enforced against legal entities and their assets.
Not against economic entities.
One only gets protection from the "group" if subsidiaries of the parent guarantee the obligations of their parent.
What are the benefits from understanding consolidated financials?
First, the “ships” of many a credit officer or “wise” investor have floundered on the conflation of “consolidated” financials with legal entity financials. Legal entity financials look much different than those of a consolidated group.
Assets (including cash) that appear in the consolidated financials that one thought were available to the Holding or Parent Company are not. Because they are assets that belong to a separately incorporated company.
One which is likely to have other shareholders (NCIs) whose permission would be required to "use" them for the Holding Company. And whose reluctance/refusal to give permission to use their "money" to bail out the Holding Company is probably a safe bet.
Absent a guarantee from the operating subsidiaries, if you lend to the parent company or invest in its securities, you have a claim against the parent company and its assets and cashflow as reflected in its legal financials.
Second, if you understand what you’re looking at, you will be able to get a better sense of the performance of the legal entity whose stock or debt you own. And whether you should accumulate or divest.
Sometimes you can get an insight into problems in the "group" merely by looking at the NCI share of income.
In 2019 the NCI share of income at GFH was minus $13 million. If we assume a 50% split between GFH shareholders and NCIs, this means that GFH also experienced a similar loss. But in GFH's case there was other income that absorbed that loss. The size of the total loss would suggest that there were problems in a major subsidiary. KHCB would be a likely candidate.
How does consolidation work?
Consolidated financials include not only 100% of the assets and liabilities of the subsidiaries and associated companies that meet the accounting tests for consolidation, but also 100% of their revenues and expenses (thus, their net income).
Any transactions between the "group" companies are eliminated, i.e., removed from the financials.
When subsidiaries are not 100% owned by the Holding Company, two adjustments are made to reflect the non controlling shareholders’ interests (NCIs).
On the balance sheet a single line adjustment is made on the liability side by creating a component of total equity called Non Controlling Interests.
No adjustment is made for assets and liabilities of the NCIs on the balance sheet. If you're looking to the consolidated financials as an indication of the assets the "group" has you should not "count" those belonging to the NCIs. But you have no idea what assets and liabilities "belong" to the NCIs.
A similar approach is taken on the income statement. A single line adjustment is made in net income for the 100% of NCI revenues and expenses by distinguishing a component called “net income attributable to NCIs” from “net income attributable to shareholders of the group”.
Keep in mind that this is a single adjustment across all the subsidiaries. If NCIs have net income of $104 in some subsidiaries and a net loss of $100 in other subsidiaries then the amount shown will be $4. Again the absence of detail is not particularly helpful for analysis.
Also keep in mind that NCIs are unlikely to be exactly the same parties across all subsidiaries.
Let's turn to Citigroup to get real life examples of these key points with the intent to make them more concrete.
To be very clear there is no negative connotation in the choice of Citigroup.
Rather there is a rich vein of information in their 2020 FY annual report. (Form 10K)
Compare this to Note 33 in JPMorgan’s FY 2020 Annual report. (Form 10K) which has less detail.
2020 Revenues (Page 301)
Citi Parent’s net income is shown on the extreme left. Citi consolidated on the extreme right with adjusting entries in the middle.
There are wide differences in amount in each revenue or expense category.
In the end the net income for both Citi Parent and Citi consolidated is equal at $11.047 billion.
But the details show that there are two critical differences between the two sets of financials.
First, Citi Parent does not conduct significant business on its own as reflected in the individual revenue and expense items. Its cashflow is largely secondhand and dependent on payments from the subsidiaries.
Second, subsidiary dividends drive Citi Parent’s cashflow. And, thus, are (a) volatile and (b) subject to constraints on payment.
In 2020 Citi Parent did not receive $9.894 billion of that year’s net income in cash (roughly 90%).
And will not until the subsidiaries pay it dividends. Until it receives the cash it cannot use it to settle obligations, make investments, etc.
Government agencies or regulators have the right to restrict the amount of dividends that a regulated firm—think primarily FIs--may pay under various measures to "protect the financial system".
In all firms shareholders must approve the payment of dividends through formal processes, e.g. AGM. So one can't simply ring up the subsidiary and ask for $1 billion in dividends by tomorrow.
As to volatility, in 2019 and 2018 (pages 302 and 303), Citi Parent received dividends 10x those in 2020. In both of those cases the dividends were more than 100% of those years’ net income.
Also look at the penultimate column on the left "consolidating adjustments". That will give you an idea of intragroup transactions "eliminated" on consolidation. You will also see this on the balance sheet, statement of cash flows.
2020 Balance Sheet (Page 304)
Here the difference is even more stark.
Citi Parent had total assets of $386.134 billion, while Citi consolidated had assets of $2,260.090 billion (almost 6x Citi Parent).
Even more telling, 95% of Citi Parent’s assets were equity in subsidiaries (55%) and advances to subsidiaries (40%). Probably most holding companies look like this. They after all are “holding” equity in subsidiaries.
Compare that to the consolidated financials where there is a greater range of asset types and a greater range of liquidity as well as much larger amounts..
That has implications when there is corporate distress.
Distress at the subsidiary level is usually but not always the cause of distress at the Parent.
At this particular time the Parent will be even more dependent on the subsidiary for cash because it most likely has no significant operations of its own. In such a case dividends are unlikely. Selling the equity in the subsidiary or pledging it as collateral is unlikely.
The most likely scenario is that the Parent will have to wait for its share from the liquidation of the subsidiary's assets.
Because the Parent holds equity in the subsidiaries, it is last in the priority of payments. Senior creditors get paid first, subordinated creditors next, and equity holders get what’s left. Usually that’s nothing or close to nothing.
There is also a risk that Parent extensions of credit to the subsidiaries may be equitably subordinated to other subsidiary creditors or recharacterized as equity. This of course depends on jurisdiction and the specific circumstances/form of the extension of credit.
If this happens, the cash flow from the subsidiary to the Parent will be even less.
Even if it doesn't, Parent Company creditors and investors are likely find themselves at the very end of the cash "waterfall".
Not where they thought they would be when they extended credit or invested.
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