Accounting for subsidiary companies.© Volodymyr/stock.adobe.com; Photo illustration Encyclopædia Britannica, IncMergers and acquisitions (known collectively as M&A) are transactions that bring together two businesses. Mergers typically combine two businesses of similar strength, while an acquisition is the purchase of a smaller company by a bigger one.

　　When two companies merge, the entities become one, and from that point on, there’s only one (combined) set of financial statements. But when a larger company acquires a smaller company—or at least a majority interest in it—the two companies typically retain their own financial statements. In such a structure, the acquiring company becomes the parent company and the acquired company becomes a subsidiary. Although the books are kept separately, the company typically also prepares (for presentation purposes) a set of consolidated financial statements—balance sheet, income statement, and statement of cash flows—that reflect combined performance.

　　Professional stock analysts—and any investor willing to do a little digging—can read and study consolidated financials, as well as the subsidiary’s standalone statements, for information about what may be driving earnings and growth.

　　Parent and subsidiary companiesA parent company owns 51% or more of the voting shares of another company and controls the operations of the smaller company. A subsidiary is owned or controlled by another company. Subsidiaries are separate legal entities and are taxed, regulated, and liable as their own company.

　　The parent-and-subsidiary relationship can be structured with specific business strategies in mind. Parents that acquire companies that operate in the same industry, increasing their market share, are said to be horizontally integrated. In contrast, vertically integrated business structures result when a parent company acquires subsidiaries that produce goods or services that the parent previously purchased from an outside source. Some conglomerates own several unrelated businesses (neither horizontal or vertical).

　　Consolidated financial statementsUnder generally accepted accounting principles (GAAP), established by the Financial Accounting Standards Board (FASB), specific rules apply when a parent company owns only part of a subsidiary. But when the parent owns 100%, consolidated financial statements generally involve these steps:

　　Combine assets and liabilities. All assets and liabilities of the companies’ balance sheets are added together line by line.Eliminate intra-entity balances and transactions. If the parent company loaned money to a subsidiary, the transaction must be removed from consolidated statements. The same goes for a vertically integrated parent or subsidiary that may act as a supplier or vendor to the other. Remove the retained earnings of a subsidiary. Consolidated retained earnings should not include the retained earnings of a subsidiary at the date of acquisition to avoid double counting. Eliminate shares of the parent that are owned by the subsidiary. If the subsidiary owns shares of the parent company, they should be reflected as treasury shares in consolidated statements (similar to shares reacquired on the open market in a company’s stock buyback program).The purpose of consolidated financial statements is to present “the results of operations and the financial position of a parent and its subsidiaries as if the consolidated group were a single economic entity,” according to FASB. Consolidated financial statements are helpful to owners, investors, and entities loaning money to the organizations, because they give a clearer picture of the entire company’s performance.

　　Analyzing parent company and subsidiary financial statementsFundamental analysis is the art and science of reading and understanding company financial statements in the context of the economic environment and competitive landscape. Financial pros and savvy investors may study ratios such as price-to-earnings (P/E), price/earnings to growth (PEG), price-to-cash-flow (P/CF), and others to analyze a company’s ability to make money now and in the future, and manage its debt and other financial obligations.

　　For an extra layer of due diligence, analysts slice and dice the numbers on the income statement and listen in on the company’s quarterly earnings call for additional context from executives during prepared remarks and a brief question-and-answer session.

　　When a parent company owns one or more subsidiaries, financial analysis becomes more complex—but also more revealing. Analysts and investors who are willing to pore through both the consolidated and standalone financial statements can sometimes spot details that aren’t visible in the headline earnings figures alone.

　　Goodwill. When a company makes an acquisition, all the costs of that acquisition—anything over and above the book value of the subsidiary—is recorded as an intangible asset—called goodwill—because it’s not a physical item. Goodwill may be the subsidiary’s brand equity, the value of its patents, or the parent company’s expectation that this acquisition will pay off over and above its cost. If you have access to consolidated and standalone balance sheets, you can compare (and track over time) the value of this goodwill to determine whether an acquisition is paying off.

　　Earnings: accretive vs. dilutive. When an acquisition is announced, management may describe the deal as being “immediately accretive to earnings”—meaning it’s expected to boost the company’s earnings per share (EPS) right away. The opposite is “dilutive,” where EPS is expected to drop at first, with the hope that the deal will pay off over time. In addition to tracking the value of goodwill, you can also monitor the earnings of the standalone company relative to the parent. Breaking it down further, you could see whether a rise or fall in the subsidiary’s earnings is due to factors on the revenue side or the expense side.

　　Company culture. Aside from whispers and anecdotes (never a great basis to make an investment decision), it’s tough to gauge a company’s culture. But there may be a few clues hidden in the parent and subsidiary financials. Key components include changes in employee retention and turnover, productivity of each workforce, and their pace of innovation, such as patent filings, new products or services, or improvements to existing ones.

　　In a successful merger or acquisition, one plus one is supposed to be greater than two. And when you consider the costs of the acquisition, it should really be three, four, or more over time. But the history books are filled with stories of failed M&A deals: AOL and Time Warner, Daimler-Benz and Chrysler, and Google and Motorola, to name a few.

　　If you own (or are considering buying) shares in a company that’s about to become a parent or a subsidiary, it’s important that you understand the value, risks, and opportunities inherent in the deal. Nothing destroys value like a failed tie-up.

　　The bottom lineA parent-subsidiary structure can streamline operations, expand market reach, and drive long-term growth—but only if the numbers (and the strategy) add up. A deal may look great on paper or make splashy headlines, but in practice, it doesn’t always translate to added shareholder value. Smart investors know the real story goes beyond headline earnings—it’s in the details of goodwill, the flow of earnings from subsidiary to parent, and whether the combined businesses operate effectively together.

　　An acquisition may look promising on paper, but the real question is whether one plus one actually adds up to more than two. And if a company whose shares you own gets swallowed up by another company—and your shares are exchanged for shares in the parent company—consider whether you’re comfortable with its strategy and outlook. Whenever an investment no longer suits your objectives or risk tolerance, it’s probably time to move on.