What is a subsidiary company?
A subsidiary company is the one that is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company. In cases, where the parent company holds 100% of the voting stock, the subsidiary company structure is referred to as a wholly owned subsidiaryWholly Owned SubsidiaryWhen a company’s almost all of the outstanding shares are owned by another company (parent) then it can be said that it is a wholly-owned subsidiary of that company and it is controlled by the parent company. For example, Walt Disney Entertainment owns 100% of Marvel Entertainment which produces movies..
Subsidiaries have a separate legal entity from that of their parent company. They are independent in terms of their liabilities, taxation, and governance. Thus, a subsidiary company structure can sue and be sued separately from its parent. Nevertheless, due to the majority ownership, the parent has a major say in the election of subsidiary’s board of directorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. and its functioning. The separate legal entity of the subsidiary may help the parent company to gain tax benefitsGain Tax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place., track the results of a unit separately, segregate subsidiary risk from the parent company, prepare assets for sale etc.
Levels of Subsidiary Company
Larger parent-subsidiary structures may involve several layers of subsidiaries, termed as a first-tier subsidiary, second-tier subsidiary, third-tier subsidiary and so on.
As shown in subsidiary company example Figure 1, where the uppermost company in the tiered structure is not owned by any other company, the subsidiaries controlled by this company is a first-tier subsidiary. Where a first-tier subsidiary owns more than 50% of shares in another entity, this entity is referred to as second-tier subsidiary and so on.
Subsidiary Company Examples
Subsidiary Company Example #1 – Walt Disney
The Walt Disney company has more than 50 subsidiaries. Partial list of subidiary companies is provided below
You may check out the full list here
Subsidiary Company Example #2 – Nike Inc
Nike Inc has more than 100 subsidiary companies. The partial list of the subsidiaries is provided below.
You may have a look at the full list of the subsidiaries here
The difference with minority passive holding and associate company
- Subsidiaries are entities where the parent or holding companyParent Or Holding CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. owns more than 50% of its voting stock.
- In contrast, if the parent holds 20%-50% of the voting stock of another company, that company is referred to as an associate company.
- Further, where the parent holds less than 20% of another company’s stock, that investment is a minority passive investment.
In the case of a subsidiary company structure, financial statements of the subsidiary are merged with the parent’s statements and the consolidated financial statements are furnished along with standalone results in the audited financials of the parent.
For minority investments, the investment is categorized as a financial investment in the asset side of the parent’s balance sheet while dividends received are shown in the income statement under financial income.
Accounting Treatment of Subsidiary Company
The consolidated financial statementsConsolidated Financial StatementsConsolidated Financial Statements are the financial statements of the overall group, which include all three key financial statements – income statement, cash flow statement, and balance sheet – and represent the sum total of its parents and all of its subsidiaries. need to incorporate all subsidiaries of the parent. All intragroup balances, transactions, income, and expenses are eliminated during consolidation. There has to be uniformity in accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level. for like transactions while combining the accounts.
- For the consolidated income statement, 100% of the subsidiary’s income and expenses are included. Any net income attributable to non-controlling interestNon-controlling InterestIt generally projects curves on the data sets. For example, to forecast population growth, forming a non-linear relationship between time and growth. of subsidiary company structure is subtracted from the consolidated net income to get the net income attributable to the parent.
- On the same lines, 100% of subsidiary’s assets and liabilities are included in the Consolidated Balance Sheet and the non-controlling interest of the subsidiary is recorded as a separate line item under equity section, labeling it as non-controlling interest in subsidiaries or minority Interest.
- The purchase price of an acquired subsidiary above its fair value is reported as Goodwill in the Parent’s balance sheet and classified as an unidentifiable asset.
- For greater than 80% ownership, the parent is required to submit consolidated tax returns.
Consolidated and Unconsolidated Subsidiary Companies
- As per regulations, parent companies are required to consolidate all subsidiary financials. However, subsidiaries may remain unconsolidated in rare cases like when a subsidiary company structure is undergoing bankruptcy wherein the parent is unable to control the subsidiary’s operations.
- Such firms are treated as equity investmentsEquity InvestmentsEquity investment is the amount pooled in by the investors in the shares of the companies listed on the stock exchange for trading. The shareholders make gain from such holdings in the form of returns or increase in stock value. and recorded in the same way as an associate investment is recorded in the parent company’s balance sheet.
Subsidiary Company Structure and Other Business Combinations
Business combinationsBusiness CombinationsA business combination is a type of transaction in which one organization acquires the other organization and therefore assumes control of the other organization's business activities and employees. In simple terms, it is a consolidation of two or more businesses to achieve a common goal by eliminating competition. can be categorized as mergers or acquisitions, consolidations and special purpose entitiesSpecial Purpose EntitiesA special-purpose entity is created to fulfill particular objectives, including devising measures to appropriate financial and legal risk profiles. It has a predefined purpose and a limited scope in terms of activity and is sometimes used as a short term solution to a current or potential problem..
While a subsidiary company structure has its own true identity and the existing organizational structure even after the acquisition by a parent or holding company, mergersMergersMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm. result in absorption of the smaller company into the larger company which purchases it, resulting in the merging company ceasing to exist. Consolidation is the formation of a completely new company through a combination of two firms while special purpose entities are created by sponsoring firm for a special purpose or a project.
Valuation Issues in Cross Holdings- EV/EBITDA
Firms with cross holdings are faced with valuation issues like in the case of EV/EBITDA estimationEV/EBITDA EstimationEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.. When a holding is categorized as a minority holding, operating incomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business. of holding company does not reflect the income of the minority holding. However, the numerator of the multiple includes the market value of equity which includes the value of minority holding thus leading to an overvaluation of the parent’s stock. Hence, the value of minority holding has to be subtracted to arrive at the correct EV.
In case of majority holding like for subsidiaries, the EBITDA includesEBITDA IncludesEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors. 100% of subsidiary operating income while the EV reflects only the portion of the holding belonging to the firm. This could give a misleading interpretation of low multiple which could categorize the holding company stock as undervalued. For consolidated holdings, adjustments would thus be required to exclude the value and operating income of the holding from the numerator and denominator respectively.
Growing businesses usually establish subsidiaries or purchase controlling stake in existing companies since this gives them the benefit of expanding their business at minimal risk. The parent-subsidiary relationship helps in locking the liabilities and credit claims of the subsidiary company structure, keeping the parent’s assets safe. There could also be other specific synergies benefitting parents, for example, increased tax benefits, diversified risk or assets like earnings, equipment or property. The subsidiary, in turn, benefits from the brand reputation of the parent company and/or valuable resources.
Although the two companies are considered separate legal entities for liability purpose, they are considered as a single entity for reporting financials. In case the holding is >80%, the parent can gain valuable tax benefits and offset profits in one business with losses in another.
Legal costs involved in acquiring subsidiaries is usually less than that of mergers. Further, the acquisitionFurther, The AcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion. of subsidiaries in foreign land results in tax benefits apart from easing business conditions with otherwise less co-operative countries. This helps to increase market share and gain competitive advantageCompetitive AdvantageCompetitive advantage refers to a benefit availed by a company that has remained successful in outdoing its competitors in the same industry by designing and implementing effective strategies in offering quality goods or services, quoting reasonable prices and maximizing the wealth of its stakeholders. through economies of scale.
This has been a guide to what is a subsidiary company. Here we discuss levels of the subsidiary company, its accounting treatment, subsidiary company structure and business combinations and valuation issues around such cross-holdings. You may also learn more about Corporate Finance for the following articles –